FEATURE: The rocky road to transparency

The process of fund managers complying with new disclosure requirements has been more complicated than many in the industry would have thought. PERE Magazine, February 2012 issue

As the saying goes, ‘The road to hell is paved with good intentions.’  Indeed, there certainly are good intentions behind the wave of new regulatory changes affecting fund reporting, namely to create more transparency in fund disclosures. However, the journey that real estate fund managers are taking to meet those new standards, while not necessarily hellish, is shaping up to be a bumpy and challenging ride.

Real estate fund managers are facing a series of deadlines to comply with regulatory initiatives that will significantly increase the amount of information fund sponsors will disclose in the future.  A major deadline comes up next month, when many real estate and other private equity fund advisers with more than $100 million in assets under management will be required to register with the US Securities and Exchange Commission under the Dodd-Frank Wall Street Reform and Consumer Protection Act.

One such real estate adviser is Waterton Associates, a Chicago-based private equity real estate firm. It raised a series of multifamily real estate investment funds including its first large commingled fund, the $500 million Waterton Residential Property Venture XI, which closed last year. The firm has about $2 billion in assets under management, including more than 17,000 apartment units and debt investments backed by multifamily properties.

The level of fund reporting “is certainly going to increase,” says Marc Swerdlow, Waterton’s president. Currently, the firm’s fund disclosures to its investors primarily consist of venture-level information, he notes. “As a result of Dodd-Frank, it’ll be much more about Waterton, its profitability and its performance – stuff we really haven’t had to disclose in the past.”

New regulations
Under a new rule adopted by the SEC last October, registered investment advisers with at least $150 million in private fund assets under management will be required to periodically file a new reporting form, Form PF, with filing slated to begin after the close of the first fiscal quarter ending on or after December 15 of this year. The information reported is intended to help the Financial Stability Oversight Council, which was established by the Dodd-Frank Act, to assess stability risks to the US financial system.

The data collection form “will address the dramatic lack of private fund information available to regulators today,” said SEC Chairman Mary Schapiro in a speech last October. For registered investment advisers, this will mean having to disclose “an unprecedented amount of portfolio information on managed private funds,” according to an internal analysis by accounting and consulting firm Ernst & Young. With Form PF, required disclosures would include the adviser’s identity and assets under management; the size, leverage and performance of all private funds subject to the reporting requirements; fund activities; certain portfolio companies; and creditors involved in financing transactions.

The SEC isn’t the only federal agency that is putting out new regulations that will affect real estate fund disclosures. Since last September, the Treasury has been requiring fund advisers to file Treasury International Capital SLT (TIC-SLT) reports on investments between master and feeder funds, which would augment existing TIC reports on transactions between master and feeder funds. At the same time, the Internal Revenue Service’s Foreign Account Tax Compliance Act (FATCA), which was enacted in 2010, requires US taxpayers, including fund sponsors, that hold foreign financial assets with an aggregate value of more than $50,000 to report certain information about those assets and investors beginning this year.

“There is absolutely a sea change that is going to happen,” says John Ferguson, a partner in the private investment funds and real estate capital markets groups at law firm Goodwin Procter. “There’s a lot of analysis going on in the marketplace right now around exactly how one properly applies a whole host of rules to an asset class that wasn’t historically subject to them.”

And when it comes to fund disclosures, real estate is a particularly tricky asset class to apply new regulations because of “incredibly varying levels of disclosure,” adds Nancy Lashine, managing director at Park Madison Partners, a New York-based placement agent. While real estate funds all focus on the same asset class, “the strategies range dramatically,” from a manager buying office properties in two markets to a global opportunity fund that’s investing all over the world.

Shades of gray
That level of variation in real estate strategy, however, hasn’t made it easy to ascertain who will be affected by the new regulations, or to what extent. “Figuring it out has been more of a challenge than many people realised,” says Elizabeth Shea Fries, a partner and head of the hedge funds practice at Goodwin Procter. “It requires more diligence and spade work.”

The new SEC fund reporting requirements are a case in point because of so-called ‘gray areas’ in terms of who will be required to become a registered investment adviser. If a private fund adviser has its principal office and place of business in the US and has more than $150 million in assets under management, even if some or all of those assets are managed outside of the US, that firm will be required to register.

A US-based private fund adviser that has less than $150 million in assets is likely an ‘exempt reporting adviser’, although with less than $100 million the firm may be subject to state regulation if the state where they are based regulates private fund advisers. A non-US private fund adviser only needs to consider assets managed from a US office. If the firm has no management in the US, it is considered to have no assets under management in the US and also will be an exempt reporting adviser.

An exempt reporting adviser, however, will be required to file part 1 of an existing reporting form, Form ADV, which has been amended to include certain reporting requirements for exempt reporting advisers. Previously, an exempt reporting adviser did not have to file any information with the SEC.

Part 1 of the ADV form requests fairly straightforward information on the fund sponsor and its fund compared to Part 2 of Form ADV, which registered investment advisers are required to complete and which involves more detailed disclosures about the company, its potential conflicts of interest, various affiliates and fees.

The SEC did not have information on the number of real estate fund managers that now will be required to register with the commission under the Dodd-Frank Act, but a spokesman says that not all real estate advisers are registered or will need to register because not all advise about securities. Generally, an interest in a limited partnership or realty trust is considered a security by the SEC; loan portfolios or joint ventures may be considered securities in some instances. Given the $150 million threshold, it is highly likely that less than 50 percent of private fund managers will be required to register, according to Ernst & Young. 

For larger real estate fund advisers required to register, there are other layers of complexity involved with reporting, such as determining which entity or entities within the organization will have to register. For example, if an adviser has a core real estate fund and a debt fund that are managed by two separate management teams and two separate legal entities, only the debt fund adviser may need to register. But if the same principals are making investment decisions for the two funds, then both funds may be required to register.

Also, in filing Form PF, a real estate fund adviser needs to determine whether it fits the definition of a real estate adviser or whether it may risk being classified as a hedge fund adviser, which is subject to more detailed disclosure obligations than a real estate fund adviser. As defined by Form PF, this can happen if a fund is authorized to borrow in excess of 50 percent of its net asset value or to have notional gross leverage in excess of twice its net asset value, including commitments.

In such a scenario, a real estate fund adviser may “want to consider whether reducing its leverage capacity or other minor restructuring consistent with its business operations may change its treatment,” so that it can be classified as a real estate fund adviser under Form PF, says Fries.

Common ground
The good news is that the various new regulations have a lot in common in terms of the information they’re soliciting from fund sponsors. About 90 percent of the information required in Form PF, Form ADV, TIC-SLT and FATCA overlaps, according to John Sampson, a regulatory compliance executive at Ernst & Young. “Not only are they going to use these same numbers to report to the various regulatory groups, but they’re also going to use these same numbers to report to investors,” he says.  “They can sleep better at night and their investors can sleep better at night because they have a higher degree of confidence.”

More of a concern than the fund disclosures themselves is establishing an internal compliance programme to support the gathering and reporting of fund information. Form PF, for example, “will take substantial time to aggregate the data,” says Rory Cohen, a partner in the corporate and securities practice at law firm Mayer Brown. “So you’re going to have to dedicate resources and technology to aggregate the data, track the data and facilitate the timely reporting of the data.”

Indeed, Waterton plans to hire additional staff, including accountants from the Big Four firms, to respond to the new fund reporting requirements. “We need those people with that type of background and training that can deal with these reporting requirements,” says Swerdlow. “The level of expertise that you need is much greater than it has been in the past.”

The transition may entail more discomfort for some real estate fund managers than others. “For some organisations, it’s just putting some level of formality around things that already take place,” such as a process to equitably allocate investments across funds or investors, or document management and retention procedures, says Sampson. For others, however, “it may involve a cultural change.”

While the new regulatory initiatives may not affect every real estate fund manager, the changes are viewed as raising the bar for the industry overall. Some advisers may choose to adopt stricter reporting standards, even if they’re not required to do so, to be more competitive and to allow institutional investors to conduct more accurate comparisons of funds. “The needle is going to move toward the SEC’s requirements,” says Fries. “It will become more of the industry standard.”

Out in the open
As regulatory requirements increase, so too do the disclosure demands of fund investors
Moving in parallel with new regulatory changes has been an increasing push by investors for more transparency in fund disclosures. “There’s a lot more scrutiny on the part of investors,” says Josh Herrenkohl, leader of real estate investors services at Ernst & Young. “There’s definitely a push toward transparency.”

Investors “are drilling down the data much more and looking for more detail,” says Marc Swerdlow, president of Waterton Associates. LPs, for example, are paying more attention to the valuation of both assets and debt, with requests for more frequent third-party appraisals of properties, and are requiring new types of disclosures, such as fees paid to the operating partner in a fund and a fund’s net returns.

Still, an investor-driven increase in the level of transparency in reporting has occurred “just very recently,” says Nancy Lashine, managing director at Park Madison Partners. “And it’s still not being done broadly.” Part of the reason is that some of the information being requested by LPs “could provide a competitive disadvantage for that manager if it was leaked to competitors in the property markets,” she explains.

Helping to drive the push toward transparency are the Institutional Limited Partners’ Association (ILPA) and its European counterpart, the Association of Investors in Non-listed Real Estate Vehicles (INREV), which have put together guidelines for institutional investors to follow when soliciting information from sponsors that are raising new funds.

Last October, ILPA released its latest set of standardised reporting templates, which focused on quarterly management reporting metrics, including a company profile, the general partner’s standard and supplemental schedule of investments, its financial results, the investment structure of its fund and capitalisation of the entire firm. The new templates followed the January 2011 release of the organisation’s first set of reporting templates on capital calls and distribution notices.

The templates are intended to “create some efficiencies between LPs and GPs in reporting, so that not every LP asks for different information and not every GP reports in a different format,” says Kathy Jeramaz-Larson, executive director of ILPA, which has been working on developing the reporting templates and best practices for the past two years.  

Luckily, there is some overlap between the new regulatory changes and the ILPA and INREV recommendations, notes Herrenkohl. Interestingly, one of the recommended questions on the LP checklist addresses whether the fund sponsor is a registered investment adviser. “There’s a level of trust that’s placed on the fact that, if an organisation is subject to some level of regulatory compliance, their data and financials will be accurate,” he says.

The information sought by the investor associations, however, goes far beyond what the regulatory bodies are requiring and “is much broader,” seeking additional details such as back-office controls and technology processes, Herrenkohl points out. GPs may not necessarily find the ILPA recommendations to be reasonable in exceeding the federal requirements, but it’s the new normal, he says. “It’s where the industry is headed.”
Real estate “has tended to be very entrepreneurial” and less mature than other industries in its operational practices, says Herrenkohl. Both investors and regulators “are forcing the industry to become more mature in terms of the way they operate.”