Waiting for Dodd-Frank

When the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law by President Barack Obama in July 2010, the legislation was expected to have a dramatic effect on how financial institutions run their operations, deal with risk and make investments. However, nearly three years after the bill was signed, some aspects have yet to emerge and be implemented. 

Indeed, after much debate and delay, a final draft of the Volcker Rule finally may be ready to rear its head. In addition, Form PF, which was implemented last year, is poised to start creating headaches for real estate fund managers.

Just how much are these aspects of Dodd-Frank expected to impact the private equity real estate industry? A few experts suggest that perhaps they may not affect the market much at all.

Even though a final draft of the Volcker Rule theoretically is set to be unveiled this quarter, it may only apply to a very small segment of the real estate market – or it may not apply at all. It all depends on how banks decide to structure their commingled vehicles. If they determine that their funds don’t fall under the definition of a private fund, then they won’t be under the jurisdiction of the rule. 

Meanwhile, Form PF already is in force, and a number of real estate fund sponsors currently are preparing for their first filings. Although the filing only applies to 1) private funds with at least $150 million in assets under management and 2) those registered with the US Securities and Exchange Commission (SEC), that would encompass a good portion of the larger private equity real estate players. 

So, what can the private real estate industry expect from these two Dodd-Frank regulations? PERE asked a few lawyers to shed some light on these rules and how they may affect the market. 

Exemptions to the rule

Originally proposed by former US Federal Reserve chairman Paul Volcker, the purpose of the Volcker Rule is to restrict US banks from making certain kinds of speculative investments that don’t benefit their customers. As it stands now, the Volcker Rule limits banks from investing in private funds, including those focused on real estate, to no more than three percent of any one fund’s capital.

So far, the sheer complexity of the rule has been a major factor in preventing it from being adopted within the financial sector. Initially, a final version of the Volcker Rule was supposed to take effect in July 2012, two years after President Obama signed Dodd-Frank. 

That July 2012 deadline, however, kept getting pushed back further and further for a number of reasons, ranging from lawmakers wanting to wait and see how the election would turn out to banks being upset by the rule’s vagueness and demanding clarity. That is in addition to the heavy workload borne by the SEC and banking regulators. 

Due to banks’ demand for a more lucidly-written law, US regulators sought public comment on the rule, delaying it even further. As a result, a final version that was supposed to be released in the summer of 2012 was delayed to the end of the year, then to the start of the 2013. Now, a final draft is expected to be released sometime in the first quarter. 

Incredibly, another potential roadblock may have emerged. Republican Congressman Spencer Bachus recently called for the Volcker Rule to be revoked altogether. The outgoing Financial Services Committee chairman says he believes the rule will hamper asset managers’ ability to grow the value of their portfolios.

Despite Bachus’ protestations, certain lawyers tell PERE that they don’t believe the Congressman has the political leverage to get Congress to ditch or delay the rule. “A lot of it is just wishful thinking. Or more accurately, politicians trying to get wishful thinkers to make campaign contributions,” says Jeff Berman, a partner at the law firm of Clifford Chance. “Last I checked, Mitt Romney lost the election.”

Gregory Lyons, a partner at Debevoise & Plimpton, agrees. “If there was a change in the election, something might have happened,” he says. “But given the way the election turned out, the chances of regulators making significant changes due to the actions of Congressman Bachus are relatively slim.” Lyons, who co-chairs his law firm’s financial institutions group, adds that he’d “be surprised if a final rule wasn’t out by the first quarter.” 

Although no one can say for certain, a number of industry observers share Lyons’ belief that a final version of the rule should emerge by the end of March, if not sooner. Currently, large banks have until July 21, 2014 to fully conform to the Volcker Rule.

Real (estate) world implications

Now that it appears a final draft of Volcker may indeed appear in the next month or two, how will it affect the private real estate space?  Ultimately, not too much. 

For one thing, the rule only applies to a very small universe of funds: those sponsored by banks. This means only a handful of platforms and funds—namely, those run by JPMorgan, Morgan Stanley, Goldman Sachs and Deutsche Bank—would be affected.  

For another, even in the case of these bank-sponsored funds, the Volcker Rule applies only to those that come within the definition of a private fund. Some banks may be able to determine that their funds are not private funds but instead fall under one of the exemptions within the Investment Advisers Act, such as those found in Sections 3(c)(1) and 3(c)(7), and therefore are not subject to the Volcker Rule.

“The Investment Advisers Act exemptions from registration were changed in such a way that they may have a potentially larger impact on real estate investment managers than the Volcker rule,” says Larry Hass, head of the global private investment funds practice group at Paul Hastings.

There are other exemptions from registration under the Investment Company Act. For example, a number of real estate funds can comply with the real estate company exemption in Section 3(c)(5) and therefore would not come within the definition of a private fund subject to the Volcker Rule.

Although few banks that would be affected by the Volcker Rule are eager to talk on the record about the provision, PERE already has seen a couple of them prepare for implementation of the rule. For example, Morgan Stanley Real Estate Investing (MSREI) has resolved not to invest more than 3 percent of the total equity in its future funds.

Furthermore, just one of MSREI’s existing real estate funds stands to contravene the Volcker Rule, namely the firm’s $3 billion open-ended Morgan Stanley Special Situations Fund III, in which it currently holds a 24 percent investment. MSREI now has a plan in place to comply with the rule in regards to this fund [See our Special Report on Morgan Stanley, starting on page 10]. Meanwhile, Goldman Sachs’ Real Estate Principal Investment Area has determined that, going forward, its real estate funds will fall under the Investment Company Act’s 3(c)(5) exemption. 

Although it remains to be seen what will happen with the Volcker Rule, odds are it will have a much greater impact on private equity and proprietary trading rather than on real estate. 

Time constraints

While the industry awaits the final version of the Volcker Rule, there is one aspect of Dodd-Frank – Form PF – that is already in place and may have a more noticeable impact on the real estate investment space. That impact? Mostly time and (some) money. 

Form PF, which collects information on private funds, is designed to allow financial regulators to monitor if there’s any systemic risk in those funds. According to a report by Ernst & Young entitled Risky reporting: Form PF in a nutshell, “Form PF will be a transitional event for many private fund firms. Form PF requires an organized effort to identify, verify, aggregate and store information from sources both inside and outside the firm.” 

Large hedge fund sponsors began to file Form PF last summer, but real estate fund sponsors that are required to file Form PF—those registered with the SEC and those with funds with at least $150 million in AUM—should begin to prepare for their first filings now. Assuming the manager has a December 31 fiscal year-end, the first filing would be due April 30, 2013. 

Although the filings are designed to collect information on certain funds, they are not designed to be public disclosure documents. Therefore, the form should not have any impact on fundraising itself. It could, however, have an effect on compliance costs.

Indeed, though there is an issue as to the type of reporting a real estate fund manager is required to do, as well as some uncertainty about the treatment of leverage and derivatives at the fund level, Jeff Berman points out that the filing of Form PF “should have no impact on fund managers’ ability to raise capital except insofar as the time it takes to prepare and file,” as well as how much the form “distracts managers from their day jobs.”

“Fund sponsors just need to be aware that this is a form that they’re filing with the SEC,” adds Ken Berman, head of Debevoise & Plimpton’s investment management practice. “They need to make sure they have sufficient quality controls in place to assure that the filing is accurate.”

Ernst & Young’s paper adds: “Form PF’s time constraints and consequences require a project approach rather than filling out a form. With thought and care, it is possible to navigate Form PF and produce results that will be useful to regulators, the firm and investors.”

A small universe

Although the Volcker Rule is likely to affect only a small universe of real estate funds, that doesn’t mean the industry shouldn’t take notice. In addition, it should be stressed that a final version of the rule still has not been released. 

“With the 113th Congress, you might see some amendments to Dodd-Frank, and you certainly could see legislative actions on Dodd-Frank,” says Dan Meade, a partner in the Washington DC office of law firm Hogan Lovells. “However, for Congress to pass anything amending the Volcker Rule, you have to wait and see what regulators actually put forth as their final rule.” 

As for Form PF, fund managers should be taking the appropriate steps now to ensure that their commingled vehicles comply with the new filing requirement.