The relationship between real estate investment managers and the US Securities and Exchange Commission (SEC) has long been a complicated one. First, there was the registration debate. Before Dodd-Frank, most real estate managers weren’t registered, and even when the deadline loomed, many real estate GPs argued that their businesses focused on properties, not securities, and they should not have to register. Eventually the industry gave in, and most surpassing the $150 million AUM threshold are now registered and awaiting possible inspection.
At the 2014 PERE CFOs and COOs Forum, a show of hands revealed that an overwhelming majority of the real estate managers in the room had not gone through an exam. That’s changing, however, as the SEC has set its sights beyond private equity and hedge funds and into the world of real estate.
Examination is inevitable, but there’s a question of preparedness on both sides of the equation. Does the SEC know enough about real estate to thoroughly and competently examine advisers? And do real estate GPs know enough about the exam process to be ready when they hear that knock on the door?
For some, the answer to the latter is unfortunately no. “Most real estate managers have almost no experience dealing with SEC exams,” says Larry Hass, partner and head of the global private investment funds group at Paul Hastings. “This is entirely new territory for them.”
The SEC’s top examiner Marc Wyatt officially announced his team had been targeting real estate in his speech at the 2015 Private Fund Compliance Forum in May, stating that the Private Funds Unit (PFU) had been undertaking a “thematic review” of real estate advisers throughout the past year. Before his speech, however, the team at ACA Compliance Group had noticed an uptick in the number of its real estate clients getting that fateful call from the regulator.
After finishing the first wave of presence exams, focusing primarily on private equity, the SEC recognized it was time to put other asset classes “on notice” too, says Luke Wilson, managing director at ACA. “Real estate was a natural next step, because there are very similar risks.”
And the regulator is not going in blind with this round of exams. The exam team has clearly beefed up its knowledge of the asset class, based on what ACA has seen. “They are more educated, and asking more thoughtful, targeted questions specific to the real estate industry,” Wilson says.
ACA has noted that the examiners’ initial document request lists are more specific to real estate now than in years past, generally including 25 to 45 items and shorter than the lists typically issued for more traditional investment advisory firms. Despite containing fewer items, the lists often require “voluminous responses,” Wilson notes.
Another challenge stems from the fact that real estate managers may not be maintaining information in the format requested by the SEC and that certain information may not be easy to access and compile across multiple funds, investments and time periods, an ACA client alert notes. ACA encourages private real estate fund managers to review a current real estate-specific SEC document request list and begin developing a response plan in preparation for an exam.
Despite the increased preparation necessary, some real estate GPs who have been examined did not find the process too threatening.
“The SEC is always going to find something, but the suggestions they had for us were really minor and actually good ideas for us to implement,” says one chief operating officer (COO) whose real estate firm was examined in 2012.
He adds that his team focused on being transparent and open with the SEC, and spent a lot of time explaining the firm’s business model to examiners to ensure they fully understood the industry. Having spoken with other recently examined advisers, he notes that the most anyone has received is a “slap on the wrist.”
“I think the industry as a whole is well prepared,” he says.
The COO is right; there hasn’t been an enforcement case against a real estate fund manager thus far. But the SEC seems to have found its first real estate-specific exam focus area: vertical integration.
A vertically integrated manager uses affiliated entities for services like property management, development, leasing and brokerage. Those managers, such as Hines or Tishman Speyer, often come from a real estate background, only delving into private commingled funds in the past decade or so. Some in the industry call themselves “operators” and their fund-focused competitors “allocators,” implying a closer relationship to the assets, and therefore, better results.
The setup, however, comes with its risks. “In vertically integrated firms, compared to purely asset management firms, the determination of what needs to be disclosed to investors relating to the allocation of expenses is much more complicated and uncertain,” says Hass.
Indeed, Wyatt called out vertical integration in his speech, saying his team had observed that some managers charge back the cost of employees who provide asset management services and in-house attorneys to their funds. The PFU examined the disclosure of such fees and expenses and found that, while sometimes the service fees are not disclosed at all, more frequently investors have allowed the manager to charge the additional fees based on the understanding that the fees would be “at or below a market rate.”
“Unfortunately, we rarely saw that the vertically integrated manager was able to substantiate claims that such fees are ‘at market or lower,’” noted Wyatt. “During some of our exams, we have seen that the manager collects no data to justify their fees at all. Other times, the data is collected informally through calls to other industry participants and is not documented. Or, when the information is collected, what is presented to investors can be misleading.”
“It’s a major problem,” says one private fund formation lawyer who specializes in real estate. She explains that the SEC is expecting to see GPs documenting other, unaffiliated bids for the same work to prove that their in-house rates are at or below market.
“It’s a flawed concept because no unaffiliated party is going to give a legitimate bid because they know they won’t get the job,” she says.
Another option would be to retain an outside source to gather market intelligence, proving with unbiased documentation that the cost associated with the service is competitive.
If vertically integrated firms that do not currently have this kind of benchmarking documentation start improving documentation and disclosures now, they might escape enforcement from the SEC, says Wilson. “If the SEC sees that you’ve gone in and taken a close look and corrected weaknesses on a go forward basis, they’re less likely to take exception.”
Institutional investors have been steadily upping their allocations to real estate for years now, so it makes sense that the SEC has been looking into possible disclosure issues in the name of investor protection. But it seems much of the investor universe is not too worried about the SEC’s take on real estate.
Wilson notes that if the SEC announces there are widespread real estate compliance deficiencies – as it did with private equity fees and expenses – it’s likely that investors will become more interested and go back to GPs with questions.
One real estate consultant who advises some of the biggest US pension plans tells pfm he would be surprised if the SEC taskforce found any suspicious activity going on in real estate, calling the decision to focus on the asset class “curious.”
For now, investors trust their relationships with GPs, and believe they are sophisticated enough to have weeded out any “suspicious activity” when negotiating fund terms.
“Investors are not going to pay much attention to what the SEC is doing,” Hass says. “Almost all of the private equity real estate funds have institutional investors, who pay very close attention to fund terms in the areas of management and administration and are very concerned that these terms are in their best interest. Firms that don’t pay attention to these issues are not long for this business.”