This week, five US regulatory agencies adopted final rules to implement the Volcker Rule, a provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act that would prohibit banks from investing more than three percent of their total equity in private funds. Still, there’s an exception to every rule and, in Volcker, there’s one of particular interest to real estate fund sponsors.
The final rules prohibit banks from owning or sponsoring private equity and hedge funds, or ‘covered funds. Covered funds would apply to any sponsor that would be considered an investment company under the Investment Company Act of 1940, even those that previously had been exempted as investment companies under sections 3(c)(1) and 3(c)(7) of the Act. Those two provisions had allowed issuers that had less than 100 shareholders or limited its investor base to ‘qualified purchasers’, respectively, to be excluded as investment companies.
Real estate fund sponsors, however, still may be able to be exempted from the Volcker Rule, thanks to section 3(c)(5)(c) of the Investment Company Act. This provision exempts an issuer from being considered an investment company if it does not invest in securities and is not primarily focused on acquiring mortgages and real estate interests. The rule therefore wouldn’t apply to fund sponsors that principally invest in real estate properties. Taking advantage of that provision, however, would require the more complicated task of monitoring a fund’s portfolio on an ongoing basis to determine whether the investments meet various percentage tests to ensure that the fund is principally invested in hard real estate assets, as opposed to securities.
Exemptions aside, the finalization of the Volcker Rule isn’t much a game-changer for the private equity real estate industry. The new legislation, after all, only affects a limited number of real estate fund sponsors – mostly investment banks, large insurance companies and other large brand-name financial institutions with fund businesses. At most, that group comprises no more than 12 to 15 of the hundreds of fund sponsors looking to raise real estate capital.
Even if some of those managers are able to avoid the impact of the Volcker Rule, that doesn’t mean they will be ramping up their real estate fund businesses anytime soon. After all, some of the worst-performing property funds in recent years were those that were sponsored by investment banks and other financial institutions. Following frightening write-downs in the wake of the global financial crisis, such sponsors will be hard-pressed to raise large funds from major institutional partners anytime soon. Other factors, including the perception of banks having less alignment of interest with limited partners, haven’t helped matters either.
In fact, we would argue that poor investment performance has hurt banks seeking to rebuild their fund businesses more than the Volcker Rule ever will. While we wouldn’t rule out the ability of investment banks to raise massive real estate funds again, that day likely isn’t on the immediate horizon.