FEATURE: An exception to every Rule

In December, five federal agencies issued the finalization of the Volcker Rule, the central provision in the overhaul of US financial regulation known as the Dodd-Frank Act.  It has been a long time in the making, giving banks ample time to prepare, but the problem has been they haven’t been able to make those preparations with total confidence because of uncertainty over the fine details. 
Most relevant to private equity real estate is the rule prohibiting commercial bank-affiliated fund sponsors from making proprietary investments of more than three percent of a fund’s total equity. 
Banks in real estate investing are now reacting in the wake of its finalization, some of them by looking for appropriate exemptions or by restructuring their funds in order to comply. The rule also is causing some banks to rethink their future endeavors in real estate, while others seem to be carrying on without a second thought.
Granted, the Volcker Rule’s final contents did not come as a surprise to those affected by it. As the regulation has been in the works for more than three years and the final version was very similar to the proposed version released for public comment in October 2011, most bank-affiliated fund sponsors already had implemented a plan for their real estate offerings that qualify under Volcker’s ‘covered funds’ provision. 
“The good news is that the proposed rule didn’t treat real estate funds too badly because many were not picked up under ‘covered funds’,” says Bill Stern, partner in the business law department at Goodwin Procter. “There was some concern that the agencies would go further than they did in the proposal, but they chose not to do that. To the extent that you have managers associated with banks, many of them already have figured out which exception they can rely on, so they don’t have to do any more.”
When the rule goes into effect in 2015, ‘covered funds’ will apply to any sponsor that is 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. These two exemptions were the most common for banks with real estate funds to rely on prior to the rule’s finalization.
Thanks to section 3(c)(5)(C) of the Investment Company Act, however, many real estate fund sponsors still may be able to be exempted from the Volcker Rule, but that exemption is not as easy to qualify under. The 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. Taking advantage of 3(c)(5)(C) requires 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. Finally, even a de minimis covered fund is prohibited from using the same name as the banking entity or any affiliate or subsidiary.
The path to compliance 
In regards to the management of current funds, most bank-affiliated firms can rely on ‘grandfather’ provisions and delayed application provisions in order to comply with the rule. “With respect to existing portfolios, by and large, there should be enough leeway for the real estate investment management firms affiliated with banks to continue managing their old generation funds and remaining assets without having to change the structure of their portfolios,” says Larry Hass, partner in the corporate department at Paul Hastings. “The rule really applies to their new business and their on-going business, to the creation of new funds and new ventures in the real estate space. That’s the big application of the Volcker rule.”
Hass estimates that the rule only applies to about 12 to 15 players of the hundreds looking to raise capital in the real estate market. However, these institutions are so large that they manage a disproportionately large amount of capital. Of those banks managing funds, some have nothing to worry about when it comes to their existing real estate business.
Take JPMorgan, for example. The bank has little to no proprietary investment in its flagship real estate offering, the JPMorgan Strategic Property Fund, and therefore can continue business as usual. Other bank-affiliated fund sponsors such as Deutsche Bank, Morgan Stanley and Goldman Sachs do not have it as easy. In anticipation of the increased regulation, these three firms have been working to restructure old funds where they had substantial proprietary investments and may have to reconsider plans to launch more opportunistic vehicles.
Through its Asset & Wealth Management (AWM) arm, which includes the firm’s real estate investment business (formerly RREEF), Deutsche has been developing new real estate investment vehicles focused on the US over the past year. Pierre Cherki, head of alternatives and real assets at Deutsche AWM, told PERE in September that, although about 80 percent to 90 percent of Deutsche AWM’s US real estate business is in core strategies, it also is working on a number of non-core offerings, including a new real estate mezzanine debt fund. At the time, Deutsche AWM expected to begin marketing those initiatives in early 2014. Given the finalization of Volcker, the bank may need to reconsider its non-core approach, as it might not qualify under 3(c)5(C). When contacted for this story, Cherki told PERE that it was too early to comment on how the regulation would affect Deutsche’s fund business.
In contrast, Morgan Stanley Real Estate Investing (MSREI) revealed last February that it would be changing the structure of one of its largest real estate funds in order to comply with the impending rule. The Morgan Stanley Special Situations Fund (SSF) III, an open-ended real estate opportunity fund launched in 2006, would be perpetually violating the regulation every quarter if left untouched. To resolve the issue, the firm chose to convert SSF III to a closed-ended vehicle, formulating a five-year plan to slowly liquidate about 40 investments valued at $2.9 billion. Morgan Stanley’s investment in the fund totaled about $700 million – approximately 24 percent of its equity – at the time of the plan’s implementation, and the firm spent more than a year in dialogue with its investors and external advisors finding a solution for the only fund in its portfolio that did not comply with Volcker.
Meanwhile, it is no secret that Goldman Sachs has been upping its involvement in the real estate debt market, and the bank apparently has been confident that Volcker wouldn’t touch debt fund strategies.  Despite the fact that risky proprietary investments were the target of the increased regulatory action, one of Volcker’s grey areas is indeed with regard to real estate loans. The final rule does not specifically include many real estate loans in its restrictions, and Goldman may be able to find leeway in 3(c)(5)(C) to make debt investments.  
In early 2013, Goldman began marketing its second mezzanine fund, which makes loans backed by office buildings, hotels, shopping centers and other properties in both the US and Europe, hoping to bring in between $2 billion and $2.5 billion from investors. Thus far, the bank has not changed this strategy despite the finalization of the rule. Goldman told investors it would contribute up to 20 percent in the fund and has raised more than $1 billion for the vehicle to date, according to a December report in the Wall Street Journal. 
Time will tell 
Banks that intend to launch funds in the future will have the added obstacle of addressing investors’ concerns, as limited partners in bank-sponsored funds have grown accustomed to managers that make substantial proprietary investments. “The interesting part about this de minimis investment rule is that it runs counter to what the limited partners typically want, which is ‘skin in the game’ from the sponsor,” adds Josh Sternoff, corporate partner in the private investment funds practice at Paul Hastings. “The question is going to be, are the investors still persuaded that, in light of the regulatory restriction, they’re comfortable with the bank having less skin in the game than they’ve come to expect? The market will bear that out.” He added that, if the answer is no, it will likely result in spinouts of the real estate teams from big banks.
Beyond its impacts on the US, the influence of this increased financial regulation has proved far-reaching, as Volcker applies to any US regulated bank, no matter where that bank is based. “Even if the investment manager is offshore, the fund is organized offshore, the investments are made offshore and the investors are all offshore, the Volcker rule will apply if the fund is affiliated with a US regulated bank,” Hass notes. The finalization of the rule has even spurred potential financial regulation from institutions abroad. A January draft proposal from the European Commission included its own version of the Volcker rule, which would outlaw proprietary trading for approximately 30 big banks, according to a report from the Financial Times. 
Representatives from Morgan Stanley, Goldman and Deutsche all told PERE that the timing was “premature” to comment on the finalization of the Volcker rule, showing that the biggest banks affected by this regulation are still waiting to see how the aftermath will impact their fund businesses. When it comes to launching a prospective fund, the greatest challenge will be complying under 3(c)5(C), should that fund invest in anything other than pure property. Sternoff notes that, at the end of the day, real estate funds have come out slightly ahead of private equity funds in the range of Volcker’s influence because they at least have the possibility of being exempt under Section 3(c)5(C) if structured in such a way that meets the requirements. 
However, Hass says that attempting to run a fund that complies with the Section 3(c)5(C) exemption but invests in “assets other than bricks-and-mortar and whole mortgage loans” over an extended period would be an “iffy proposition.” As the exemption must be tested on a quarterly basis, he points out that funds that make their investments over a four- to five-year period could very well encounter issues in the long run. 
“It’s easy to say that you have the foresight to launch the fund now, but things change, opportunities come along, things happen,” Hass says. “What looks like it might be easy to comply with in 2013 could end up being a lot more complicated come 2018.” The banks have until July 2015 to wind down their non-complying funds or to find just the right structure to ensure they are safely exempt, at least for now.