Tangled in red tape

Regulators gave the private equity and real estate fund industry something to worry about in 2012. More of the same is expected in 2013 and beyond. PERE Magazine, February 2013 issue.


The various pieces of policy created in response to the global financial crisis – which many would argue unfairly targeted and fundamentally misunderstood private equity and real estate fund managers – are now getting their final touches or have reached the first stages of implementation. 

As a result, thousands of private investment fund managers, both in the US and abroad, have for the first time fallen under the purview of the US Securities & Exchange Commission (SEC), with registration compulsory as of March 2012. In Europe, some countries have begun transposing pieces of the Alternative Investment Fund Managers (AIFM) directive into national law. And in emerging markets, most notably China and India, regulators are working to develop clear and comprehensive policies in step with industry growth.

All of this means more time and resources – and greater compliance risks – for private equity and real estate fund managers going forward. SEC registration, for example, mandates that all firms designate a chief compliance officer, write formal compliance manuals and make other so-called ‘back office’ preparations in order to be ready for a possible surprise visit from SEC inspectors. In Europe, increased compliance costs will stem from the AIFM directive’s rules on risk management, disclosure and reporting and, perhaps most significantly, the requirement that GPs pay a depository to safe-keep investors’ assets (an arguably useless rule for illiquid private assets, which are less prone to abuse or misplacement). 

A study launched by the UK’s Financial Service Authority estimates the AIFM directive would impose an estimated one-off compliance cost of up to €3.2 billion on EU private funds and ongoing compliance costs of around €311 million thereafter. These costs no doubt have the potential to become an irritant for LPs, notes Daniel Green, partner at international law firm Pinsent Masons. “The attitude of investors may become more pronounced when the costs of compliance are clearer and when they realize that most of those costs will be passed on to them,” he says. 

More globally, the directive’s “third country” rules on non-EU funds and managers have created a heated debate about whether some GPs will abandon Europe to avoid burdensome AIFM rules. The rules would prohibit foreign fund managers from marketing within the EU unless they can demonstrate that they are subject to a regulatory regime of equivalent rigor in their home country. Similarly, offshore islands with relatively lax regulatory regimes secretly fret some GPs will move onshore to avoid the risk of being ring-fenced from EU investors and target companies.

In the emerging markets, the industry continues to track China’s creation of a national framework for private funds. China’s quickly growing private equity industry was given a foundation for national fundraising regulation in late 2011, which will require large onshore funds to register with the country’s National Development and Reform Commission and submit fund information for review. In line with the new rules, GPs can no longer use websites, publications, messages or conferences to market their funds to the general public – similar to the US Securities and Exchange Commission’s Regulation D – nor can they use commercial banks or securities companies to transmit the fund information for them.

Meanwhile, in India, the experience continues to be bittersweet for fund managers: regulators have created a more comprehensive national funds framework, but they have categorized fund types into awkward boxes that will in some cases restrict their investment strategies. India’s private funds regime will require all alternative investment funds (AIFs) – meaning private equity funds, real estate funds, hedge funds, fund of funds and so on – to register with the Securities and Exchange Board of India.

In Brazil, lengthy review periods and exhaustive notification forms will increase the difficulty of closing M&A transactions. The updated notification form contains extensive requests for documents and data and is likely to be even more burdensome and time consuming than equivalent EU merger documents. The form requires market assessment studies, board and committee minutes, plus marketing reports and business plans of the merged entity. Still, Brazil also is representative of a growing trend in Latin America, which in the hunt for global capital is slowly “westernizing” its private equity rulebooks.

By far the biggest regulatory concern for GPs may come from the US Foreign Account Tax Compliance Act (FATCA), which requires foreign firms to provide US tax authorities with the name, address, tax identification number and other key financial details of any US investors or suffer a 30 percent withholding tax on certain US-connected payments. In the US government’s attempt to clamp down on overseas tax dodgers, foreign GPs caught by FATCA have been left struggling with how to verify investors’ tax documents, whether the bill forces them to breach local privacy laws by submitting information to US tax authorities and even the question of who at the firm ultimately is responsible for managing FATCA compliance. US-based firms, meanwhile, wonder if FATCA will inspire other countries to make similar tax information demands on their foreign investors, which could open the door to an unimaginably complicated global tax information exchange network.

LP regulation

Already feeling the trickle-down effects of regulations covering private investment firms, LPs also are coming to terms with rulemaking directly impacting their investment activities. The global crackdown on banks’ exposure to “risky” assets is effectively restricting some of real estate’s biggest players from future commitments. 

In Europe, the third installment of the Basel Accords, designed to discourage excessive risk-taking, introduced higher liquidity requirements for banks, which eventually will force them to sell off a substantial portion of their private equity and real estate holdings. In the US, the so-called Volcker Rule (part of the Dodd-Frank Wall Street Reform and Consumer Protection Act) dictates that banks must limit their exposure to alternatives to no more than 3 percent of their Tier 1 capital and cannot own more than 3 percent of any private equity or real estate group.

“Banks are facing increasing pressure on their balance sheets, and they continue to sell non-core assets,” says Andrew Sealey, managing partner of advisory firm Campbell Lutyens. “If anything, we’ve seen an acceleration of divestment programs.”

The impact of Volcker alone is significantly complicating banks relationships with GPs in fundraising mode. Many in the industry expected the rule to be softened during consultation phases (and with a good dose of lobbying from the financial services industry), but a series of banking scandals throughout 2012 – including the suspected rigging of London interbank lending rates – hasn’t helped matters. At press time, US regulators still were in the process of fine-tuning Volcker, but there isn’t ample hope that once finalised banks will have a clear sense of their obligations. Questions still surround how banks can convert their in-house funds into compliant customer funds (under the proposal, banks can sponsor funds for both new and existing customers where the fund’s underlying risk are fully borne by the customers themselves). Other questions relate to whether or not real estate funds will be exempted from the rule’s scope. 

What’s more, it appears sovereign wealth funds, like their banking cousins, also may be restricted in making private investments and commitments under Volcker.  Some sovereign wealth funds, such as China Investment Corporation, could fall under the definition of a “bank holding company” in the US because they own more than a 5 percent stake in a bank with a US presence. They may be able to push back on that definition by avoiding various regulatory “control” thresholds, but a 25 percent ownership stake in a bank with a US branch guarantees the definition sticks. 

Just how much is at stake? Sovereign wealth funds collectively manage some $5 trillion in assets, according to the Sovereign Wealth Fund Institute. Assuming a 5 percent real estate allocation in your average sovereign’s portfolio, that translates to $250 billion in commitments that could be cut down in size as a result of the rule (though it’s impossible to know by just how much, considering the private nature of sovereign wealth funds). 

Institutional investors in Europe may have it worse from a regulatory perspective. EU policymakers are set to introduce complicated risk-based capital holding rules for insurance companies and pension plans. Under Solvency II, EU insurance firms essentially will need to set aside €25 for every €100 invested in direct property and perhaps more for funds. In all, European insurers hold some €7 trillion in assets, according to credit rating agency Fitch. And while hard numbers are difficult to come by and vary by country, sources say that insurance firms typically allocate between 5 percent and 10 percent of their portfolio to real estate – translating to roughly €350 billion to €700 billion at stake in Europe.

What’s more, EU policymakers currently are considering how they could transpose Solvency II capital requirement rules to EU pension plans – or, as critics describe it, a lazy copy-and-paste job. Industry trade bodies have for good reason criticized the move. In a consultation submission to the European Insurance and Pensions Authority, the market watchdog responsible for supervising the new insurance and pension rules, the European Private Equity and Venture Capital Association (EVCA) argued that the proposed reforms favor liquidity over capital at risk. As long-term investors, this could make it difficult for pension plans to meet liabilities as they fall due. With respect to fundraising, GPs would be interested to know that pension plans accounted for some 36 percent of all capital raised by EU-based GPs between 2006 to 2010, according to EVCA stats.

In many ways, 2012 was the year the private equity and real estate industries first experienced significant supervision. However, with many rules still yet to be finalized, it’s no surprise the issue remains front-of-mind for many investors. How industry executives engage with government and regulatory bodies moving forward and navigate all those tangles of red tape will forever impact the future shape of the global private equity and real estate markets.