GPs face a host of challenges as they look ahead to 2011 and beyond – not least regulation from governments globally. In the US, regulations impacting GPs, including the Volcker Rule and required SEC registration, have been pushed through, while Europe’s Alternative Investment Fund Managers directive has stalled. PERE magazine Fund Administration supplement, September 2010

The private equity real estate industry is facing a number of regulatory changes in the US and Europe that will change the scope of how GPs manage their firms for years, if not decades, to come.

In the US, significant regulatory initiatives have already been passed by lawmakers, while in Europe politicians have postponed planned reforms. GPs have spent the past year watching both sides of the Atlantic with care, knowing only too well that in both cases the fallout of the regulatory rule changes will spread well beyond US and European borders.

Most notable of the changes is the move by the US Senate making registration with the Securities and Exchange Commission a reality for most private equity and real estate firms. The law will force most managers to face regular inspections by the SEC, designate a compliance officer and explicitly outline how to deal with potential conflicts of interest, among other requirements.

Indeed, President Barack Obama on 21 July signed off on long-awaited financial reform, which includes the Volcker Rule and SEC registration requirements, ending months of congressional debate.


The legislation, the Restoring American Financial Stability Act of 2010, requires private equity and real estate firms with $150 million or more in assets to register with the SEC. Under the new registration requirements, private equity and real estate firms will need to establish formal compliance policies to outline how they would deal with potential conflicts of interest. Registration also means firms need to designate or hire a compliance officer, as well as face regular inspections by the SEC.

While many US-based real estate managers were anticipating the outcome, some non-US managers were surprised that they will have to register with the SEC as well.

Under the Dodd-Frank Act – part of the Restoring American Financial Stability Act of 2010 – foreign private equity and real estate firms with more than 15 US-based LPs, at least one office in the US and more than $25 million in combined US investor assets will have to register with the SEC.

“The bill will have a big impact on non-US private equity funds,” says James Seevers, head of the private equity practice group at Virginia-based law firm, Hunton & Williams. “The Advisers Act means there will be two regulatory regimes for non-US funds, their home country and now the US.”.

By keeping the exemption extremely narrow, the Dodd-Frank Act will force real estate investment managers based outside the US to assess whether they need to form a US investment advisor to manage assets in the US or whether the final SEC rules and regulations provide relief from any of the requirements of the Advisers Act.

“This provision could potentially bring many foreign investment advisors with very few US contacts under the ambit of SEC registration. The exemption may ultimately affect foreign advisors’ decisions on whether to seek US investors,” according to a client briefing from US-based law firm Gibson Dunn.

Volcker limitations

It is the so-called Volcker Rule that has generated much of the publicity for the financial reform act though. Named after the former Federal Reserve chairman, Paul Volcker, who developed the rule, it will strictly limit banks’ proprietary trading activities with regard to private equity, real estate and hedge funds.

The rule originally called for US banks to choose between running private equity and private equity real estate operations and taking deposits. However, after much political wrangling and lobbying – and several days spent reconciling two separate financial reform bills – Congress agreed in July to cap a bank’s co-investment in its own private equity and real estate funds to no more than 3 percent of the total commitments of the fund. Banks will also be limited to investing a total of 3 percent of its tier 1 capital ratio in its overall private equity, real estate hedge fund vehicles.

The changes are certainly dramatic, and have prompted much speculation as to whether some banks will shed their sponsored platforms or accept a dramatic scaling back of co-investment capability. For instance, as of 31 March, Morgan Stanley had invested the equivalent of 9 percent of its almost $50 billion of tier 1 capital in its own hedge fund, private equity and real estate funds, while Goldman Sachs had invested roughly 22 percent, with $15.4 billion of equity invested in such vehicles against a tier 1 capital reserve of $69.4 billion. In the past both banks have invested up to 20 percent of the total commitments in their own real estate funds.

A lot depends on how regulators impose the transition period [for banks] but implementation of the Volcker Rule could be anything from four to 12 years.

Kevin Petrasic, counsel at Paul Hastings’ banking and financial institution practice

The scaling back of bank co-investment won’t be made immediately, however. The industry has been given up to 12 years to implement the changes.

In passing the new act, Congress called for a newly-created Financial Stability Oversight Council to study the issue for six months before recommending regulations on how the Volcker Rule should be introduced. The Federal Reserve and SEC, among other federal agencies, will then have another nine months to review those recommendations and make their own suggestions. At most the government will have two years from the time President Obama signed the bill into law to recommend how the Volcker Rule will be implemented.
Kevin Petrasic, counsel at Paul Hastings’ banking and financial institution practice, says the US government has also given itself a lot of flexibility on timing.

In addition to the two years, banks have been allowed a two-year “transition” period to implement the changes, together with the possibility of three one-year extensions. After that time, the Federal Reserve has the right to give banks operating “illiquid funds” – such as private equity real estate – a further five years to comply with the new regulations, meaning the longest available transition period would be 12 years, and allowing most closed-ended funds the opportunity to run the natural course of their life.
“A lot depends on how regulators impose the transition period [for banks] but implementation of the Volcker Rule could be anything from four to 12 years,” Petrasic adds.

Developments in Europe

Regulatory initiatives in Europe are a different story. The region’s main regulatory agenda has stalled as private equity real estate managers wait for resolution on the EU’s Alternative Investment Fund Managers (AIFM) directive.


A vote was expected to take place on 6 July, but has once again been postponed as politicians continue to debate the issues. Instead, the private equity real estate industry must hold on until September to learn what the AIFM directive will look like after talks between the European Parliament and the European Council broke down at the end of June when politicians failed to reach a consensus on items such as the “third party” or “passport” rule.

The passport rule – aimed at determining how and where managers can market their funds in the EU – is one of the main sticking points of the directive amid fears it could restrict capital flows in and out of Europe.
During a debate in the British parliament – a fierce critic of the directive – in July, Baroness Cohen of Pimlico voiced concerns over disadvantaging non-EU fund managers and EU investors, as well as regarding the controversial “third country” rules, which have been addressed differently in two drafts of the directive.

The European Council of Ministers’ has introduced one version that allows for national private placement regimes to continue, provided there are cooperation agreements in place between a particular EU country’s regulator and the regulator of the third country where the fund is domiciled. If the fund manager wins the seal of approval from that particular EU country, the manager could then freely market throughout the EU.
However, a different version of the directive has been approved by the EU Parliament’s Economic and Monetary Affairs Committee (ECON), which would prohibit foreign fund managers from marketing within the EU unless they can demonstrate that they are subject to a regulatory regime of equivalent rigour in their home country. Should this version pass, the manager must gain approval from each EU nation to get the much-needed passport.

If you’re a US fund manager, then you would, under the [ECON] text, need to go through a number of requirements and the outcome might not be the same for you in each country in the EU.

Elizabeth Ward, counsel at Linklaters

Speaking for the UK government, commercial secretary Lord Sassoon reiterated that EU negotiations were “far from over”. A definitive document reconciling the two drafts had been expected by the end of July, but the timeline has been pushed out to September.

On third country arrangements, what he called “perhaps the most difficult issue under the directive”, Lord Sassoon said the directive should be non-discriminatory and should not restrict investor access. “It is critical that EU investors should continue to be able to access alternative investment fund management throughout the world. In line with these principles, the [UK] government will push for what we call a dual regime, with an achievable EU passport operating alongside national regimes.”

Again, the different versions of the directive will have different implications for European and US fund managers.

“If you’re a US fund manager, then you would, under the [ECON] text, need to go through a number of requirements and the outcome might not be the same for you in each country in the EU,” says Elizabeth Ward, counsel at Linklaters. “Some countries regulators might recognise equivalence, whereas others may not so willingly.

“Another concern is the uncertainty at the moment,” she adds. “We have different texts of the directive on the table, and you can’t really advise funds on what will happen because there isn’t enough certainty.”