For the past year, the US Securities and Exchange Commission (SEC) has inspired fear and loathing among real estate registered investment advisors (RIAs) that have been subjected to an examination by the federal agency. In fact, one investment manager likened the experience to a proctology exam.
According to a widely quoted industry statistic, at least 80 percent of these exams have resulted in deficiency or comment letters, meaning that the SEC has identified certain violations or issues that it would like the RIA to rectify. During a keynote interview at the PERE CFOs and COOs Forum in New York in July, Igor Rozenblit, a top SEC private funds inspector, cited that statistic and then made a compelling but somewhat controversial remark.
Touching on Kohlberg Kravis Roberts’ $30 million settlement with the SEC over its misallocation of broken deal expenses to its private equity funds, Rozneblit acknowledged that the firm wasn’t wrong in its defense that what it did was simply industry practice. However, he argued that it still didn’t mean it was legal from a regulatory perspective.
According to Rozenblit, some of the more egregious violations uncovered during SEC exams included: providing investors with misleading data in order to make fees appear to be at or below market; charging higher rates to the fund than to third-party clients; and billing employee hours back to the fund when investors ask the manager how it calculates its property management fees.
If you ask managers, however, the issue isn’t so black and white. In fact, one manager who was in the audience during the Rozenblit keynote was “particularly disgusted” by the inspector’s remarks. If a firm is actually hiding fees and deliberately withholding information from investors, then it wholly deserves to be slapped with an SEC enforcement action, he said.
Most firms, however, aren’t intentionally doing anything wrong, he asserted, although public speeches made by SEC officials such as Rozenblit can give the impression that they are “on a bit of a witch hunt.” In fact, managers are scared of getting flagged by the SEC, as enforcement action would be “a big black mark” that would make it hard for a firm to operate and continue raising funds, another fund manager said.
One manager acknowledged that mistakes do happen when allocating expenses, but said that typically these misallocations involve relatively small amounts of money and that the manager is just as likely to be incorrectly billed for expenses as the fund itself. He said that SEC should put thresholds in place that would take into account issues such as the size of the misallocation or whether or not the violation was a first-time offense and allow some minor offenses not to become part of a firm’s permanent record, he said.
Some firms also point out that some of the industry practices that the SEC is calling illegal have been part of limited partner agreements that have been signed and approved by their investors for years. It’s only in the past few years that managers have become RIAs and therefore subject to SEC regulations.
The big problem, however, is that managers often don’t have idea of how some of the regulations apply to private equity real estate funds. Many firms receive deficiency letters without any explanation on what they should be doing instead, said one such manager. SEC guidance, if any, tends to come in piecemeal, he added.
Another fund manager noted that some of the areas where they have been cited in deficiency letters are gray areas, where the agency has not taken a clear position on an issue. “If you’re saying that there’s all these industry practices that are illegal, why don’t you publicly clarify which industry practices are illegal?” he asked. Compliance, rather than being a straightforward process, instead has become a guessing game.
Firms also have expressed frustration at the fact that SEC inspectors have typically had little to no knowledge of the industry. This led one manager to question how qualified most inspectors were to be writing up deficiency letters on private equity real estate firms in the first place.
The fund manager who attended the Rozenblit interview, however, said he was pleasantly surprised by the inspector’s knowledge of the private equity real estate industry and considered it a positive step forward. In his view, the SEC is starting to specialize “in our area,” whereas previously regulators tended to make mountains out of molehills because they didn’t understand the business.
Seeing better educated regulators should lead to more confidence in how the SEC is handling its oversight of real estate RIAs. The agency indeed has come a long way in understanding real estate fund managers since examinations began. But the education process on both sides of the table is still far from complete.