As discussed in the recent Ropes & Gray Alert “SEC Adopts New Private Fund Adviser Rules”, the SEC adopted new private fund reforms on August 23, 2023. While these reforms apply broadly to “private funds”1 regardless of structure or strategy, the substance of the rules gives rise to unique considerations with respect to real estate funds. The following is a summary of these considerations.
Characterization of a Real Estate Fund as a “Private Fund”
Real estate funds often have more flexibility than other private funds (such as private equity funds and hedge funds) in determining their reason for not being required to register as an “investment company” under the Investment Company Act of 1940 (the “Investment Company Act”). Historically, many real estate funds have relied on the so-called “private fund exclusions” provided by Sections 3(c)(1) and 3(c)(7) of the Investment Company Act due to the benefits afforded by such exclusions. However, the advent of the new private fund reforms, the recently adopted SEC marketing rules, and the recently proposed revisions to the SEC custody rules, each of which only applies to private funds, provide new incentives for real estate advisers to revisit the basis upon which their real estate funds are not required to register as an “investment company.”
In particular, many real estate funds may simply fall outside of the definition of “investment company” or could potentially rely on the exclusion set forth in Section 3(c)(5)(C) of the Investment Company Act. A real estate fund would fall outside the definition of “investment company” under Section 3(a) if it invests primarily in real property, does not hold itself out as being engaged primarily in the business of investing, reinvesting or trading in securities, and invests less than 40% of its assets at all times in securities. Alternatively, if a real estate funds asset composition were such that it falls within the definition of “investment company,” it could potentially rely on Section 3(c)(5)(C), which excludes from the investment company definition any person who is “primarily engaged in the [business of] purchasing or otherwise acquiring mortgages and other liens on or interests in real estate.”
Going forward, real estate funds advisers may wish to take one of the aforementioned approaches for all their newly formed real estate funds so that the new private fund rules, among others, would not apply to their real estate funds. For existing real estate funds that have been relying on Section 3(c)(1) or 3(c)(7), it may be possible to change their Investment Company Act position, but doing so may be more challenging depending on how such funds historically have been reported on the adviser’s Form ADV as well as other regulatory filings such as Form PF and Form D. However, if a fund were to make changes such that it could no longer rely on the Section 3(c)(1) or 3(c)(7) exclusion, then it would reduce the risks associated with a change in its Investment Company Act position. For example, a fund that currently relies on Section 3(c)(1) could admit more than 100 investors, and a fund that currently relies on Section 3(c)(7) could admit one or more investors that do not qualify as “qualified purchasers” or “knowledgeable employees.” In each case, such action would justify the fund changing its Investment Company Act analysis.
To further distinguish real estate funds from other private funds, a fund sponsor may consider moving its real estate business to an unregistered adviser affiliate. However, we note that many institutional investors prefer, and in some cases require, that a fund’s investment manager be SEC-registered. In addition, there may be operational challenges with moving a real estate business to an unregistered adviser affiliate because the same team at a sponsor may manage real estate funds that are both private funds (because they invest in securities) and not private funds.
Is an Open-End Real Estate Fund a “Liquid Fund”?
Unlike other open-end funds, such as hedge funds that trade public securities, the real properties held by open-end real estate funds are less liquid, private investments. As a result, the redemption mechanics in an open-end real estate fund typically provide broad discretion to the fund’s general partner to postpone redemptions (often via a redemption queue) until sufficient cash is available to satisfy redemption requests. Importantly, open-end real estate funds often are not required to sell assets, borrow capital, or cease investment activity to meet redemption requests. This begs the question of whether an open-end real estate fund could be considered an “illiquid fund” for purposes of the new private fund rules.
The distinction between “liquid funds” and “illiquid funds” impacts the application of the new private fund rules with respect to multiple topics—for example, the new private fund rules include distinct processes for disclosing preferential terms for liquid and illiquid funds, and reporting requirements and performance methodologies2 differ between liquid and illiquid funds. Open-end and closed-end real estate funds managed by the same adviser may be more likely to hold overlapping assets than open-end hedge funds and closed-end private equity funds managed by the same adviser. As such, real estate fund advisers have a greater interest in streamlining reporting and other disclosures where possible (e.g., by treating an open-end fund as an “illiquid fund” to ensure consistent reporting and disclosure with closed-end funds that hold the same assets).
Given the narrow definition of “illiquid fund” in the private fund rules,3 it may be difficult to argue that an open-end real estate fund fits such definition, since investors typically retain the ability to request redemptions on a periodic basis (usually quarterly). Nevertheless, real estate fund advisers may wish to take the distinction into consideration when launching new products.
Defining a “Similar Pool of Assets” – Parallel Funds, Co-Investment Vehicles and Joint Ventures
Real estate funds have unique structuring arrangements. The new private fund rules prohibit the granting of preferential redemption and information rights to investors within a private fund and any “similar pool of assets,”4 which generally picks up any parallel funds and feeder funds but may also extend to co-investment vehicles and joint ventures on a case-by-case basis, as discussed further below.
Notably, the adopting release suggests that the term “similar pool of assets” includes a variety of pooled vehicles, regardless of whether they are “private funds.”5 As such, even if a parallel or feeder vehicle relies on a different exemption (e.g., it claims the 3(c)(5)(C) exemption or is structured as a collective investment trust), it may need to be taken into consideration for purposes of the preferential treatment prohibitions.6 Notwithstanding the foregoing, an adviser does not need to take such similar pools of assets into consideration when complying with the preferential treatment disclosure requirements set forth in the rules, which only require disclosure of preferential rights (other than those relating to preferential information and redemption) granted to investors (e.g., via side letter) in the same private fund (i.e., the same legal entity).
While parallel funds and feeder funds would seem to be clear cases of “similar pools of assets,” co-investment vehicles and joint ventures must be considered on a case-by-case basis. A co-investment vehicle that makes multiple investments alongside a private fund is more likely to have substantially similar investment policies, objectives, or strategies as such private fund and to expose investors to similar risks than a co-investment vehicle that only invests alongside a multi-investment private fund in a single investment. Further, preferential treatment granted in respect of a similar pool of assets only is prohibited where it would be reasonably likely to have a material negative effect on investors in the private fund. A material negative effect would be less likely to occur (and more difficult to prove) where two investment vehicles do not have significantly overlapping portfolios.7
Joint ventures, which often are used in the real estate space, typically afford the money partner a variety of major decision rights with respect to actions taken by the operating or developer partner that are not provided to passive investors invested in the same underlying assets through a typical commingled fund. Real estate fund advisers will need to be mindful of documenting the position taken with respect to each joint venture in which their clients invest—a joint venture where the adviser’s client has numerous decision rights and governance powers is less likely to be viewed as a similar pool of assets than one where the adviser’s client is a passive investor. Similar to a single-investment co-investment vehicle, a multi-investment private fund may only make one of its investments through a joint venture, in which case it is less likely that the fund and that joint venture would be deemed to be similar pools of assets.
Disclosure of Adviser Compensation – Considerations for Vertically Integrated Managers
Fund managers in the real estate space often are vertically integrated, where the adviser’s affiliates provide non-advisory services such as property management, brokerage, development, financing, and leasing services to real estate funds and their subsidiaries. The new private fund rules require quarterly statements that present a detailed accounting of any compensation, fees, and other amounts allocated or paid to the adviser or any of its related persons, including in connection with services such as those listed above.
Real estate fund advisers should note that such quarterly statements will require separate line items for each category of compensation (presented both before and after the application of any offsets, rebates or waivers), with no miscellaneous or “catch-all” items. Separate line items may not be required where the same category of compensation (e.g., a fee paid in respect of a particular type of service) is paid to multiple affiliates.
Quarterly Portfolio Investment Disclosure – Real Estate Fund Subsidiary Structures
As noted above, real estate funds often have multiple layers of subsidiaries, including real estate investment trusts (“REITs”) and property holding special purpose vehicles, at which different fees may be paid depending on the level at which services are provided. The quarterly reporting requirements set forth in the new private fund rules require reporting at the level of each “covered portfolio investment,”8 which will capture any such subsidiaries that compensate the adviser or its related persons during the reporting period. As such, there is no reporting requirement at the entity level where the relevant entity pays fees solely to third parties.9
While the rules do not provide complete clarity on application to more complicated structures, we believe that the below approaches are reasonable:
- Where a subsidiary (such as a REIT subsidiary) is directly paying a fee to an adviser or its related persons, the adviser would be required to disclose such fee in the fund’s statements and the statements of the relevant subsidiary but would not be required to disclose such fee in the statements of any intermediary vehicles, such as holding companies.
- Where a fee is paid at one level in a structure but allocated to another level in the structure (e.g., a fee paid at the fund level but allocated down to the property level, or a fee paid by a joint venture, which may not be a private fund, that is partially allocated to the fund), the fee should be reported at both levels, but a footnote should be included in the statements of the entity at which the fee is actually being paid to indicate the allocation to the other entity.
While approaches to conveying complicated fee structures such as those noted above may differ, it is critical that advisers clearly communicate to investors the fees that they are ultimately bearing and the services to which such fees are attributable.
Annual Audit Requirement – Real Estate Fund REIT Subsidiary Structures
The mandatory private fund adviser audits rule requires a registered investment adviser providing investment advice, directly or indirectly, to a private fund, to cause that fund to undergo a financial statement audit that meets the requirements set forth in paragraphs (b)(4)(i) through (b)(4)(iii) of Rule 206(4)-2 under the Advisers Act (the “Custody Rule”) and to cause audited financial statements to be delivered in accordance with paragraph (c) of the Custody Rule.
In real estate fund structures, REIT subsidiaries often enter into separate investment advisory agreements with the adviser, and a portion of the overall management fee is paid to the adviser at the REIT subsidiary level. Where an adviser employs this structure, it should be aware that a full audit will be required at the REIT subsidiary level unless the REIT subsidiary is not considered to be a “private fund” (either by qualifying for the 3(c)(5)(C) exclusion or falling outside the definition of “investment company”). Alternatively, it may be possible to take the position that the REIT subsidiary is not a client of the adviser.
Preferential Redemption and Information Rights – “Material Negative Effect” Standard
The prohibitions on preferential redemption and information rights within a private fund or a similar pool of assets only apply where such preferential rights would be reasonably likely to have a material negative effect on investors in the fund or similar pool of assets. Where the investments held by such vehicles are less liquid, as is often the case in real estate funds, the likelihood of a material negative effect is notably higher, if not inevitable. As a result, real estate advisers should pay special attention to the granting of any such preferential rights.
- A “private fund” is a fund that would be an investment company, as defined in section 3 of the Investment Company Act, but for section 3(c)(1) or 3(c)(7). See Investment Advisers Act of 1940 (15 U.S.C. 80b) Section 202(a)(29).
- Because the private funds rules require liquid funds and illiquid funds use different performance metrics in reports, private funds that are technically “liquid funds” (because they permit withdrawals) but hold less-liquid assets (such as open-ended real estate funds) may consider reporting performance using the required “liquid fund” metrics and metrics that are more traditionally used for illiquid funds in order to avoid investor confusion.
- An “illiquid fund” is defined as one that (i) is not required to redeem interests upon an investor’s request and (ii) has limited opportunities, if any, for investors to withdraw before termination of the fund. A “liquid fund” includes any other fund. See 17 CFR 275. 211(h)(1)-1 (defining “illiquid fund” and “liquid fund”).
- A “similar pool of assets” is another pooled investment vehicle (other than a registered investment company, a company that elects to be regulated as such, or a securitized asset fund)) with “substantially similar investment policies, objectives, or strategies” as the private fund managed by the investment adviser or its related persons. See 17 CFR 275. 211(h)(1)-1 (defining “similar pool of assets”).
- See Release No. IA-6383; File No. S7-03-22 (the “Adopting Release”), at 287. However, elsewhere in the rules under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), a “pooled investment vehicle” is defined as “any investment company as defined in section 3(a) of the Investment Company Act of 1940 or any company that would be an investment company under section 3(a) of that Act but for the exclusion provided from that definition by either section 3(c)(1) or section 3(c)(7) of that Act,” (i.e., the definition elsewhere includes only registered investment companies and private funds). See 17 CFR 275. 206(4)-8.
- Note that separately managed accounts are not included in the definition of “similar pool of assets”; however, there are certain circumstances where a fund-of-one can be a pooled investment vehicle and fall within the definition. See Adopting Release, at 289.
- Note, however, that the definition of “similar pool of assets” does not specifically refer to overlapping assets, and therefore does not clearly distinguish a single asset co-investment vehicle from a sidecar vehicle that co-invests alongside a fund in multiple assets whenever there is available capacity.
- “Portfolio investment” means any entity or issuer in which the private fund has directly or indirectly invested. See 17 CFR 275. 211(h)(1)-1 (defining “portfolio investment”). “Covered portfolio investment” means a portfolio investment that allocated or paid the investment adviser or its related persons any compensation, fees and other amounts attributable to the private fund’s interest in such portfolio investment (including, but not limited to, origination, management, consulting, monitoring, servicing, transaction, administrative, advisory, closing, disposition, directors, trustees or similar fees or payments) during the reporting period. See 17 CFR 275. 211(h)(1)-1 (defining “covered portfolio investment” and “portfolio investment compensation”).
- Note also that the definition of “portfolio investment” refers to an entity or issuer and does not extend to properties themselves. If an entity owns multiple properties, there is no requirement to break out statements for each property.
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