With the US Securities and Exchange Commission, Federal Deposit Insurance Corporation and Federal Reserve all requesting public comment on restrictions in the Dodd-Frank Act this week, a big step has been made towards severely limiting the ability of banks to own or sponsor private equity funds. However, the proposed restriction, known as the Volcker rule, has wound up causing more confusion than providing clarification.
“It's not written in a way that it can be a final rule at this point,” said Dan Meade, a partner in the Washington DC office of law firm Hogan Lovells. “No one's happy with it.”
Indeed, Meade – who recently rejoined Hogan Lovells after spending 15 months as senior counsel to the US House Financial Services Committee, where he was a principal draftsperson of the Dodd-Frank Act – pointed out that the industry finds the rule as written to be too onerous, while some — such as consumer advocates — find it to be not strict enough.
As it currently stands, the proposed Volcker rule would ban banks from taking positions held for 60 days or less, change the way traders involved in market-making are compensated and make senior bankers responsible for compliance, among numerous other restrictions and safeguards. Created to combat “systemic risk,” the biggest impact for PERE readers would be the 3 percent threshhold for banks to own and operate hedge and private equity funds, including those focused on real estate. Under the rule, banks must limit their investment in private equity to no more than 3 percent of their Tier 1 capital, with an additional restriction from acquiring more than a 3 percent ownership stake in any fund.
Not that there are many banks with real estate investment platforms left to begin with. In fact, it appears as though Goldman Sachs, JPMorgan, Morgan Stanley and Deutsche Bank are the only banking giants that continue to play in the space.
In addition, word is the new Volcker rule is vague about rules concerning mezzanine debt funds. After all, lending is considered a core activity of most banks and US regulators would be loathe to further reduce the already muted level of lending activity, particularly since they have spent the past couple of years and millions of taxpayer dollars trying to foster it. Some banks have had success with these types of vehicles and are eager to know the rule's ultimate stance on them.
So, is the Volcker rule a death knell for bank-sponsored real estate funds? More to the point, could it serve as a boon to the independent fund manager?
According to Meade, the Volcker rule could prove too costly for the Goldmans of the world to stay in the private equity real estate space. “Regardless of how the final rule comes out, it's pretty clear that banking entities won’t be able to rely on the 3(c)(1) and 3(c)(7) private equity exemptions to structure their real estate funds,” he said. However, “they may try hard to structure their real estate funds under the 3(c)(5) exemption, which isn’t covered by the Volcker rule.”
With fewer players like Goldman and Morgan Stanley, the void in the market could provide some additional opportunities for independent fund managers, Meade pointed out. After all, if the big banks think that staying compliant costs too much, they may play in the space less. On the other hand, independent fund managers, which are not subject to the rule, will have lower compliance costs and fewer restrictions, not to mention fewer competitors.
Vagaries aside, the Volcker rule may have nothing to do with banks leaving the private equity real estate market. Indeed, they may be leaving of their own volition. After all, as previously noted, few players remain.
Stephen Tomlinson, senior partner in Kirkland & Ellis’ real estate practice group, noted that a number of these firms are exiting the real estate fund business and focussing on their core businesses. “If you look at the behaviour of institutional investors of late, they're getting more thoughtful as to how to deploy their balance sheets,” he said. “Many banks also have moved on for performance reasons, as well as the regulatory environment.”
At the end of the day, it would have been better if the Volcker rule had been clearer. For now, most banks find themselves in limbo and erring on the side of caution. In other words, they are not likely to be launching new funds or creating new structures for fear of running afoul of the final rule.
As things stand, most players seem to be in agreement that it's still too early to tell and, with a final version of the Volcker rule not slated to take effect until 21 July 2012, there's still a long way to go. Ultimately, however, we may be calling the time of death for the bank-sponsored real estate fund sooner than previously expected.