Yes, the SEC Wants Real Estate Fund Managers to Register

After six months baking in the oven, the new Form ADV is ready. (To be more precise, the new Part 1 is ready. Part 2 has been sitting on the table for almost a year.) Form ADV still calls for real estate fund managers to register as investment advisers

Earlier I had pointed out how a real estate fund manager could be considered an investment adviser and have to register with the SEC under the Investment Advisers Act. In the Proposed Changes to Form ADV the SEC included “real estate fund”. They also changed the way you calculate assets under management, taking in the value of the fund assets, not just securities held by the fund.

While waiting for Form ADV to finish baking, I wondered if there might be some clarification or changes to pull real estate funds out of the registration requirement. It didn’t happen.

As you can see from the image above, “real estate fund” is still one of the choices when it comes to designating the type of fund. That gives it equal status with hedge fund, venture capital fund, and private equity fund. The definition of real estate fund is unchanged in the instructions for Part 1A of Form ADV:

“Real estate fund” means any private fund that is not a hedge fund, that does not provide investors with redemption rights in the ordinary course, and that invests primarily in real estate and real estate related assets.

Maybe there is room under the definition of “private fund”? In the Glossary it’s defined as “An issuer that would be an investment company as defined in section 3 of the Investment Company Act of 1940 but for section 3(c)(1) or 3(c)(7) of that Act.” That does leave open the position that the fund could be exempt under section 3(c)(5). That’s a murkier exemption than the one provided by 3(c)(1) or 3(c)(7).

The other confusion over how to value the assets under management is gone. The old version of Form ADV had a 50% test for assets under management. If less than 50% of the value was not securities, then you didn’t have a securities portfolio and the value was zero.

The new way of calculating assets under management for a private fund from the Instructions for Part 1A:

For purposes of this definition, treat all of the assets of a private fund as a securities portfolio, regardless of the nature of such assets. For accounts of private funds, moreover, include in the securities portfolio any uncalled commitment pursuant to which a person is obligated to acquire an interest in, or make a capital contribution to, the private fund.

It still gets back to being a “private fund” and relying on a 3(c)(1) or 3(c)(7), instead of a 3(c)(5) definition. One thing to realize is that the definition of “private fund” actually comes from Section 402 of Dodd-Frank, not from the wishes of the SEC. The intent of the SEC is clear, even if there may be some wiggle room.

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14 Responses to Yes, the SEC Wants Real Estate Fund Managers to Register

  1. Alexander Davie July 13, 2011 at 2:51 am #

    This is an interesting observation, re: Form ADV. However, while Form ADV does mention real estate funds, I don’t believe there is any statute or regulation requiring such registration. In order for someone to qualify as an investment adviser, and thus have the requirement to register, they would have to be giving advice on securities. Since a real estate fund holds no securities (as long as the fund directly purchases real estate), its general partner or managing member falls completely outside the definition of the term “investment adviser” regardless of the contents of Form ADV. Therefore no registration is required by law.

    In addition, a real estate fund would not normally be a “private fund” because the definition of a private fund is that it would be an “investment company” but for sections 3(c)(1) or 3(c)(7) of the Investment Company Act. But a real estate fund falls outside the definition of an “investment company” which is defined (I’m paraphrasing) as a company whose assets are at least 40% securities. Since a real estate fund is not an investment company regardless of sections 3(c)(1) or 3(c)(7), it would not be a “private fund.”

    • Doug Cornelius July 13, 2011 at 6:07 am #

      Alexander – You are right to point out the other side of the argument.

      Most of the real estate fund managers I’ve talk to have a mix of assets and ways they acquire real estate. Buying joint venture interests, using REITs and other vehicles to re-characterize income, buying debt, and other non-bricks and mortar activities make the analysis more difficult. Those could all be considered securities. How much advice about securities does there need to be?

      As for the Investment Company Act, I generally see funds relying on 3(c)(1) or 3(c)(7) because they are bright-line tests. Can you go back and now say that you are exempt under 3(c)(5)?

      The final piece is investor perception. Currently, there is no expectation that their alternative fund mangers be registered. I’m not sure that expectation will be true next year.

      Now we add some SEC intent to the mix.

      Roll that all together and the decision to register or not register is complicated.

      • Alexander Davie July 13, 2011 at 9:20 am #

        Good point. When I read your article, I understood you to be talking about a fund that owns actual real estate. After making my earlier comment, I read your excellent piece on whether real estate can be a security (http://bit.ly/aN6byT). So, now I realize your article was talking about a wider range of assets. But you are right, a fund that owns limited partnership interests in real estate or stock in companies that own real estate would be an investment company or private fund if over 40% of the assets were securities. One question for thought: at what % does the trigger occur of investment adviser registration? Is it also 40% or something lower?

        Another question: why is it that funds that purchase commercial mortgages secured by a first lien an real estate use the 3(c)(5) exception, when they could easily claim that commercial mortgages are not securities (and thus out of the Investment Co Act altogether). Is there any authority out there that deems commercial mortgages securities? That would make every borrower an issuer, which simply could not be true.

        • Doug Cornelius July 13, 2011 at 10:17 am #

          I think people are unsure about the percentages and characterization of ownership. Pure bricks and mortar are not securities, but often the ownership is not so straight-forward. Some have taken the position that mere cash management could be enough to make you an investment adviser with the abolishment of the 15 client exemption.

          I get the general sense that first lien mortgages are unlikely to be considered securities in the hands of the original lender. However, participation interests and higher tranches in the capital stack seem suspect.

          I think the real estate industry largely ignored these issues for years because they could rely on the 15 client exemption. Now people are taking a closer look at how real estate is treated under the Investment Advisers Act. Nobody likes what they see. It’s murky, with arguments on both sides.

  2. Michael Minces July 23, 2011 at 3:12 pm #

    I was forwarded your article by a colleague and the discussion coincides with several conversations that we have been having with real estate managers. I think that Alexander is correct to focus on the definition of investment company under ICA Section 3(a)(1)(c), which is an issuer that:

    “is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 percentum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis”

    Investment securities are then defined as “all securities except (A) Government securities, (B) securities issued by employees’ securities companies, and (C) securities issued by majority-owned subsidiaries of the owner which (i) are not investment companies, and (ii) are not relying on the exception from the definition of investment company in paragraph (1) or (7) of subsection (c).”

    Considering the ADV 1 definition of a Real Estate fund is tied to the concept of private fund (e.g. 3c-1 or 3c-7), it would seem that the fund would have to trip the investment company definition (40% of its assets in securities) in order to need to rely on private fund exemptions. So, any registration requirement would be highly dependent on an analysis of the assets of each RE fund. Funds that pool investor capital to invest directly in hard real estate (i.e. the fund owns a development, building, strip mall, etc.) should not raise any investment adviser registration issues. However, a RE fund that pools investor capital to invest in multiple real estate investment through multiple special purpose vehicles is a fund that owns multiple limited partnership and LLC interests, which are securities and if they consitute more than 40% of the fund’s assets, would raise a registration requirement for the fund’s manager. An additional interesting point is that if the fund does hold more than 40% of its assets in real estate investment partnership interests, but some of those interests are greater than 50% of the relevant RE partnership, then they would not be considered “investment securities” as defined in Section 3(a)(1)(c), and would not count toward the 40% threshold.

    From a RE manager’s perspective, this analysis is going to be an important one going forward because if their structure requires the manager to be registered and they continue operations unregistered, they can be exposed to significant business regulatory risk from an investor compliant or commerial contract viability perspective.

    • Young Fund Manager July 24, 2011 at 10:55 pm #

      I have just received interest from accredited friends and family members to raise $1 million plus to invest in Real Estate Tax Deed/Certificates from county government tax sales. I have a basis PPM and LLC agreement, but have been advised to seek advise on whether I am exempt. The issue being are real estate tax deeds considered a security or an investment in real estate?

      Does anyone have insight into this issue or direct me to a firm that is very familiar with privat real estate LLCs?
      Thanks
      George

    • Doug Cornelius July 25, 2011 at 8:13 am #

      Michael -

      I agree that many real estate managers can make the argument that they are not an investment company. I think there is good argument to be made if the SEC shows up at your doorsteps and asks why you’re not registered.

      Although, I think many fund managers have been using the 3(c)(1) or 3(c)(7) exemption as the benchmark. Many people get concerned about what happens when you corporate blockers between the real estate and the fund. What do you do if you have made prior statements that your fund is exempt under one of those exemptions?

      The other issue is investor perception. Most of the big real estate fund managers are registered. See http://www.compliancebuilding.com/2011/05/09/are-real-estate-fund-managers-registered-with-the-sec/

      Today, most investors don’t seem to care if you are not registered. Will that be the case a year from now?

  3. Michael Minces July 25, 2011 at 10:27 am #

    Doug – any benefit of identifying an exemption for a fund will only matter to RE advisers if all of their funds are structured to be exempt and they only advise on real estate. As your research has identified, many large managers run multiple types of assets, and non-RE assets frequently require SEC registration. The analysis above that is specific to real estate is only really pertinent to your typical residential and commercial real estate groups. With these groups, my experience has been that they arent aware of the 3c-1 or 3c-7 exemption categories, which makes sense because they arent investing in securities. One problem with these new rules, however, is that if the specific assets of a RE fund require SEC registration of an unregistered manager under the new Dodd Frank rules, then the fund investors have to be qualified clients for the manager to receive a preformance interest on the fund’s investments. Most of these types of funds dont have that built into the documents and will likely have to go back to thier investors for that qualification.

    • Doug Cornelius July 25, 2011 at 3:53 pm #

      Michael –

      That’s the rub. By choosing to stay outside of the boundaries of registration you are limiting the investment options for your real estate funds.

      One example I heard thrown about is this. You intend to make bricks and mortar investments, with just a sprinkling of real estate securities (let’s say distressed mezz debt). However the first investment is a mezz debt investment before you buy make any direct real estate investments. Have you just blown the investment company definition and now need to find an exemption? If you would, maybe you need to pass on the investment.

      Each manger will need to decide if the costs of registration exceed the investment limitations and possible negative investor perception. (I have heard of investors that require SEC registration before investing in a RE Fund.)

    • Doug Cornelius July 27, 2011 at 10:28 am #

      Michael -

      I also forgot to point out the interplay with state level regulation. Registration with the SEC removes you from state level registration. By taking the position that the fund is not an “investment company” and takes you out of SEC oversight, you then need to look at the state definition of investment adviser and available exemptions.

      State level regulatory regimes are in turmoil as they are trying to figure out what the post Dodd-Frank era means for them. States are tightening their regulatory oversight and removing exemptions. Most mangers I’ve talked to when given the choice between state and federal registration chose federal.

  4. Daniel Meyer August 26, 2011 at 5:07 pm #

    Doug,

    I have been following your Blog for a while now (just as I have been carefully following the passage of Dodd-Frank and the regulations promulgated thereunder).

    Your analysis with respect to real estate funds (and the comments above) are all in line with my own on the issue and I have been grappling with what the post-Dodd-Frank regulatory landscape will look like. I’m concerned with the shift of regulatory responsibility from the SEC to state regulators under Dodd-Frank – particularly since it is coming at a time when many states are dealing with severe budgetary constraints and fewer resources to absorb this.

    I am also very concerned with real estate funds and their managers having to rely on 3(c)(5)(C) in order to get around Dodd-Frank’s amendments to the Advisers Act because, as you know, satisfying the 3(c)(5)(C) “real estate program” exemption depends on the fund’s assets under management falling within the (to paraphrase) “primarily engaged in acquiring/owning/disposing of real estate assets and interests therein” threshold – which is largely the product of a handful of SEC No Action Letters rather than more definitive regulations.

    I look forward to hearing your thoughts on this (particularly as it pertains to real estate funds that, as part of their investment strategies, originate first-mortgage loans and mezzanine loans on real estate assets). It has been my understanding that the SEC had indicated in the past that mezzanine loans on real estate could fall within the definition of “interests in real estate” – notwithstanding the fact that such loans are secured by the equity interests in the operating entity formed by the fund to take ownership of the subject real estate asset.

    In any event, it should be interesting to see how all of this pans out.

    • Daniel Meyer August 29, 2011 at 12:31 pm #

      Re: my previous post, I meant to say “such loans are secured by the equity interests in the borrower entity” not the operating entity formed by the fund.

      I am also interested to see how the new process/rules for calculating regulatory assets under management will play out. First, I wonder if a fund that obtains a line of credit secured by its uncalled capital commitments will have to count the uncalled amount twice (i.e., once for the uncalled capital amount and again for the amount of leverage obtained by pledging that uncalled capital amount). Second, I wonder how it will work for a real estate loan fund that obtains a warehouse facility in an attempt to maximize returns – will the fund also have to count the warehouse debt and, if so, will it have to count the maximum drawdown amount or just what it has actually borrowed at any given time? Finally, how would the ebb and flow of borrowing play out in terms of a fund possibly moving back and forth between regulatory regimes based on AUM?

      • Doug Cornelius August 29, 2011 at 9:43 pm #

        Daniel -

        As for the shift in responsibilities to the state, I think it works well for the SEC. I haven’t done the research, but most of the SEC litigation actions against advisers seems to be against those with less than $100 million in assets. That means the SEC can jump in and take action under the anti-fraud provisions but lay the blame on the state regulators for not stopping the problem sooner.

        Finding the line between real estate and securities is fun for the first week of a securities law class, but not for fund trying to stay in the boundaries of the law. I think mezz debt can fall on either side of line depending on the level of control.

        Lastly, on the calculation of assets under management, I’m a bit confused on how to include debt. Form ADV says to use the value you report to investors. The release notes say to add in debt. I think the result could be to add the subscription credit line on top of the capital commitments. I need to go back and look closer at it. Since you have seen the same problem, I’m glad that I’m not alone in trying to figure out what the SEC wants.

  5. Daniel Meyer August 30, 2011 at 9:54 am #

    Doug,

    I would say you are correct as to the interplay between the SEC and state regulators. There is little doubt that the SEC prefers this new regime. The question that remains, however, is how well the individual state legislatures and regulatory bodies will do in effectuating the intent of Dodd-Frank as it pertains to advisers.

    I agree with you as to the “what is a security, exactly” analysis, and the SEC’s inclusion of “real estate funds” on the new Form ADV certainly doesn’t help matters. I keep going back to the redlines I made to the 1940 Acts shortly after Dodd-Frank’s passage and am still scratching my head as to how we even got here. At the time, I felt so very confident that real estate funds (i.e., predominantly “pure” real estate funds with extremely limited exposure to non-real estate-related assets in their portfolios) would not get pulled into the mix along with hedge funds and LBO-focused PE funds. Mezz debt will likely remain an outlier until it isn’t anymore. Same goes for how to calculate AUM, I suppose.

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