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Private Equity Real Estate Top 30 – 2012 Edition

Private Equity Real Estate just released its ranking of the top 30 real estate private equity fund managers. As I have done in the past, I parsed the list to see which managers are registered with the Securities and Exchange Commission as investment advisers. (Disclosure: my company is on the list.)

1 The Blackstone Group Registered
2 Morgan Stanley Real Estate Investing Registered
3 Goldman Sachs Real Estate Principal Investment Area Registered
4 Tishman Speyer Registered
5 Colony Capital Registered
6 The Carlyle Group Registered
7 Lone Star Funds (Hudson Advisors) Registered
8 Beacon Capital Partners Registered
9 Westbrook Partners Registered
10 LaSalle Investment Management Registered
11 MGPA Registered
12 Starwood Capital Group Registered
13 CBRE Global Investors Registered
14 AREA Property Partners Registered
15 Prudential Real Estate Investors Registered
16 TA Associates Realty Registered
17 Angelo, Gordon & Co Registered
18 Rockpoint Group Registered
19 Shorenstein Properties
20 Bank of America Merrill Lynch Global Principal Investments Registered
21 AEW Global Registered
22 Hines Registered
23 Brookfield Asset Management Registered
24 Lubert-Adler Real Estate Registered
25 JER Partners Registered
26 Grove International Partners Registered
27 CIM Group
28 Northwood Investors Registered
29 DRA Advisors Registered
30 Walton Street Capital Registered
Other Real Estate Fund Managers  —
GI Partners Registered
KSL Capital Registered
Aetos Capital Registered
Citi Property Investors Registered
Lehman Brothers Real Estate Private Equity Registered
Crow Family Registered
Jamestown, LP Registered
KK daVinci Advisers
Rockwood Capital Registered
RREEF Alternative Investments Registered
Rockefeller Group Registered

 

It still stands that 28 of the top 30 are registered with the SEC as Investment Advisers.

There are good arguments to be made on both sides of the registration debate for real estate funds. The core requirement under the Investment Advisers Act is that the manager is giving investment advice about securities. Most of these real estate fund managers are truly focused on real estate and not securities. However, the discussion between what is and is not a security may be fun for the first week of your securities law class in law school. It’s not a fun discussion when trying to comply with regulatory requirements.

The PERE 30 measures capital raised for direct real estate investment through commingled vehicles, together with co-investment capital, over the past five years.

Sources:

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.

Sources:

Are you an Investment Company?

Fund managers are dealing with Dodd-Frank and the requirements under the Investment Advisers Act made by the Securities and Exchange Commission. Of course, a fund manager needs to focus on other areas of financial regulation and enforcement by the Securities and Exchange Commission. Fund managers need to keep focused on how they comply with the Investment Company Act.

Section 3 of the Investment Company Act has this definition:

1. When used in this title, “investment company” means any issuer which–

A. is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities;

B. is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificate outstanding; or

C. 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.

This leaves you with the tricky analysis of whether your investments are securities. To avoid that mess, most private funds look to two exemptions from the definition of “investment company”: 3(c)1 and 3(c)7.

Under 3(c)(1), the main limitations are that you have one hundred or fewer holders of beneficial interest in the fund and that you do not propose to sell them in a public offering. Under 3(c)(7) you can go beyond the 100 owners, but they need to be “qualified purchasers.” That means they need to have a big wallet.

One challenge for private funds who do not want to register under the Investment Advisers Act is that private fund is defined as an “issuer that would be an investment company as defined in Section 3 of  the Investment Company Act, but for section 3(c)(1) and section 3(c)(7) of that Act.”

There are other exemption available, but they are harder to fit under. You may have a trail of paper work stating that you fall under the section 3(c)(1) or section 3(c)(7) exemption, even though you could claim to fit under one of the other exemptions.

For example, 3(c)(5) is available for real estate funds:

Any person who is not engaged in the business of issuing redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates, and who is primarily engaged in one or more of the following businesses: …  (C) purchasing or otherwise acquiring mortgages and other liens on and interest in real estate.

There are some additional limitations that come with this based on some SEC No Action letters. I’ll put some information together on that later.

Sources:

Image is Exchange hall, Copenhagen, Denmark, between ca. 1890 and ca. 1900, published by The Library of Congress

Are you an Investment Adviser?

There has been a lot of focus on the effect of Dodd-Frank on private fund managers. Many had relied on the small adviser exception from registration. If you had fewer than 15 clients (funds) you were exempt from regulation. With the loss of that exclusion, the industry has been looking to other ways to fall outside the requirements of registration.

One may be to take another look at the definition of investment adviser and see if it really applies to what your fund does.

Section 202(a)(11) of the Advisers Act defines an “investment adviser” as

“any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.”

Let’s break it down into its three components:

  1. for compensation
  2. engaged in the business
  3. provide advice about securities

A person or firm must satisfy all three elements and not fall into one of the half dozen statutory exclusions to be regulated under the Advisers Act.

For fund managers, the “compensation” is easily satisfied. A fund manager is giving advice to its funds. Presumably, they are not doing it for free.

The term “securities” is very broadly defined in Section 202(a)(18) of the Investment Advisers Act.

Whether a person providing financially related services is an “investment adviser” is a facts and circumstances test. In  Release IA-1092 (.pdf) the SEC took a look at whether financial planners are investment advisers and provided some ways to look at whether you are in “engaged in the business” of “providing advice about securities.”

Here are some activities that the SEC believes falls into the category:

  • Giving advice about securities, even if it does not relate to specific securities
  • advise concerning the relative advantages and disadvantages of investing in securities in general as compared to other investments
  • in the course of developing a financial plan for a client, advises the client as to the desirability of investing in, purchasing or selling securities
  • a person who advises employee benefit plans on funding plan benefits by investing in, purchase, or selling securities, as opposed to, or in addition to, insurance products, real estate not involving securities, or other funding media
  • providing advice as to the selection or retention of an investment manager (under certain circumstances)

“Engaging in the business” of providing investment advice is a little trickier. Giving advice need not be the principal business activity. “The Giving of advice need only be done on such a basis that it constitutes a business activity occurring with some regularity. The frequency of the activity is a factor, but it is not determinative.”

It comes down to how often a fund manager gives advice to the fund about securities as part of the fund’s operations and investment process.

Sources:

Image is Have a Heart. by A. Golden / CC BY-NC-ND 2.0

Custody and Private Funds

Last year, the Securities and Exchange Commission put a new rule in place restricting an investment adviser’s ability to have custody of its clients’ assets. Given that many private fund managers are going to have to register as investment advisers they need to figure out how to comply with this rule.

The rule is the anti-Madoff rule. The SEC wants client assets separate from the manager’s control and for the manager to safeguards in place to prevent a manager from sending out false statements to investors. This includes having a third party custodian and having the custodian send statements directly to investors and subjecting the accounts to a surprise inspection by an auditor.

Safekeeping required

Rule 206(4)-2(a) If you are an investment adviser registered or required to be registered under section 203 of the Act, it is a fraudulent, deceptive, or manipulative act, practice or course of business within the meaning of section 206(4) of the Act for you to have custody of client funds or securities unless:

(1) A qualified custodian maintains those funds and securities:

(i) In a separate account for each client under that client’s name; or

(ii) In accounts that contain only your clients’ funds and securities, under your name as agent or trustee for the clients.

If your fund has securities, then you need a “qualified custodian” holding those securities. There is an exception for “privately offered securities” that will make life much easier for private equity funds and real estate funds.

Use of a Qualified Custodian

So who can you use as a “qualified custodian“?

(d)(6) Qualified custodian means:

(i) A bank as defined in section 202(a)(2) of the Advisers Act or a savings association as defined in section 3(b)(1) of the Federal Deposit Insurance Act (12 U.S.C. 1813(b)(1)) that has deposits insured by the Federal Deposit Insurance Corporation under the Federal Deposit Insurance Act (12 U.S.C. 1811);

(ii) A broker-dealer registered under section 15(b)(1) of the Securities Exchange Act of 1934, holding the client assets in customer accounts;

(iii) A futures commission merchant registered under section 4f(a) of the Commodity Exchange Act (7 U.S.C. 6f(a)), holding the client assets in customer accounts, but only with respect to clients’ funds and security futures, or other securities incidental to transactions in contracts for the purchase or sale of a commodity for future delivery and options thereon; and

(iv) A foreign financial institution that customarily holds financial assets for its customers, provided that the foreign financial institution keeps the advisory clients’ assets in customer accounts segregated from its proprietary assets.

Surprise audits and custodian statements

In addition to the requirement in (a)(1) that a qualified custodian hold the securities, there are addition requirements in (a)(2), (a)(3) and (a)(4) that you notify the client about the custodian, require separate statements be sent to the client and that the account be subject to surprise audits.

When investment funds are the clients these requirements make less sense, so (a)(5) requires funds to send the account statements to their limited partners.

There is an exception for pooled investment vehicles:

(b)(4) Limited Partnerships subject to annual audit. You are not required to comply with paragraphs (a)(2) and (a)(3) of this section and you shall be deemed to have complied with paragraph (a)(4) of this section with respect to the account of a limited partnership (or limited liability company, or another type of pooled investment vehicle) that is subject to audit (as defined in rule 1-02(d) of Regulation S-X (17 CFR 210.1-02(d))):

(i) At least annually and distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) within 120 days of the end of its fiscal year;

(ii) By an independent public accountant that is registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by, the Public Company Accounting Oversight Board in accordance with its rules; and

(iii) Upon liquidation and distributes its audited financial statements prepared in accordance with generally accepted accounting principles to all limited partners (or members or other beneficial owners) promptly after the completion of such audit.

If your auditor is not subject to inspection by PCAOB, you would have to switch auditing firms for your private fund to use this exception. You need to make sure your auditing firm has the horsepower to get the audited down in time for you to get financial statements out in within 120 days of fiscal year end.

Certain privately offered securities

There is a exception for having to deliver “privately offered securities” to the qualified custodian. Certain privately offered securities are:

(A) Acquired from the issuer in a transaction or chain of transactions not involving any public offering;

(B) Uncertificated, and ownership thereof is recorded only on the books of the issuer or its transfer agent in the name of the client; and

(C) Transferable only with prior consent of the issuer or holders of the outstanding securities of the issuer.

Notes and Interests in Subsidiaries and Portfolio Companies

For real estate private equity, the problem will be notes. They may be considered securities. Notes won’t meet the definition of uncertificated and they are most likely transferable.

For entities and portfolio companies, the key will be to make sure the subsidiaries under the funds are not certificated and there is requirement for consent in order to transfer. I think fund managers are going to have to back and inventory their subsidiary entity documents.

Of course you may be able to make an argument that the interest in the subsidiary is not a security. If it’s wholly-owned you can make a strong argument that the ownership is not a security since you are not relying solely on the efforts of others. But if the subsidiary is corporation you may be stuck treating it as a security. It’s generally hard to argue that shares in a corporation are not a security.

In the SEC Q&A about the custody rule:

Question II.3

Q: If an adviser manages client assets that are not funds or securities, does the amended custody rule require the adviser to maintain these assets with a qualified custodian?

A: No. Rule 206(4)-2 applies only to clients’ funds and securities.

So you don’t need to deliver all of the fund assets to the custodian. Just those that are securities and cash. Presumably, fund managers are already keeping their funds’ cash in a bank account and not in a mattress. They just need to make sure that the cash accounts are in the fund names.

At first, I thought the limited partnership exception would allow private fund managers to completely avoid the burden of this rule. That was too broad. Now I think fund managers are stuck with hiring a qualified custodian if they register with the SEC. I would guess there will lots of private fund managers looking for custodians before they register.

Sources:

ARMOR * PLATE / ptufts / http://creativecommons.org/licenses/by-nc-sa/2.0/

Update on the Social Media Policies Database

My social media policies database is now up to 162 policies. I troll the internet periodically to add new policies as they become public.

If you are looking to draft your own social media policy, the policies in the database are a good place to start.

Currently they are organized into these industries

  • Education (5)
  • Financial (2)
  • Government (40)
  • Healthcare (17)
  • Law Firm (3)
  • Media (18)
  • Non-profit (11)
  • Professional services (16)
  • Retail (10)
  • Sports (3)
  • Technology (24)
  • Utility (1)

Plus, there are a 10 generic templates.

Clearly, government is over-weighted in the database. Is it because government bodies are ahead of private industry when it comes to creating social media policies? I doubt it. I think they are just more likely to publish the policy or otherwise make it publicly available.

If you want to contribute a policy to the database, you can use the form below.

Social media bandwagon image is by Matt Hamm under a creative commons license.

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The Knowledgeable Employee Exemption for Private Funds

UPDATE: See More Guidance on Knowledgeable Employee Exemption for Private Funds

When operating under the Section 3(c)(7) exemption from the Investment Company Act, the issue then becomes how a private investment fund can provide an equity ownership to key employees.

Its unlikely that your key employees will have the $5 million in investments needed to qualify as an investor. (Each investor in a 3(c)(7) private investment fund must be Qualified Purchaser.)

The SEC established Rule 3C-5 to allow “knowledgeable employees” to invest in their company’s private fund without having to be a qualified purchaser. The rule also exempts these knowledgeable employees from the 100 investor limit under the Section 3(c)(1) exemption from the Investment Company Act.

You will still need to determine if the employee’s acquisition of the interest is exempt from the registration requirements of the Securities Act. Most likely that will mean that the knowledgeable employee will need to be an accredited investor. Meeting that $200,000 per year / $300,000 per year if married income (and a reasonable expectation of that income continuing) threshold may be the biggest impediment to offering equity interests further down the company ladder.

The first category of “knowledgeable employees” is the management of the covered company, which covers these positions:

  • director [see Section 2(a)(12)]
  • trustee
  • general partner
  • advisory board member [see Section 2(a)(1)]
  • “executive officer”

Executive Officer is defined in Rule 3C-5 as:

  • president
  • vice president in charge of a principal business unit, division or function
  • any other officer who performs a policy-making function
  • any other person who performs a similar policy-making function

The second group of knowledgeable employees are those who participate in the investment activities. Those employees need to meet these requirements:

  • Participate in the investment activities in connection with his or her regular functions or duties,
  • has been performing such functions and duties for at least 12 months, and
  • is not performing solely clerical, secretarial or administrative functions.

The 12 month limit is not limited to 12 months at the employee’s current company. The SEC concluded that it is not necessary to require that an employee work for the particular fund or management affiliate for the entire 12-month period as long as the employee has the requisite experience to appreciate the risks of investing in the fund and performed substantially similar functions or duties for another company during that 12 month period.

Whether an employee actively “participates in the investment activities” of a private fund will be a factual determination made on a case-by-case basis.  In a 1999 No Action letter sent to the ABA the SEC said the following would NOT be knowledge employees:

  • Marketing and investor relations professionals who explain potential and actual portfolio investments of a fund and the investment decision-making process and strategy being followed to clients and prospective investors and interface among the fund, the portfolio mangers and the fund’s clients.
  • Attorneys who
    • provide advice in the preparation of offering documents and the negotiation of related agreements,
    • who also are familiar with investment company management issues, and
    • respond to questions or give advice concerning ongoing fund investments, operations and compliance matters.
  • Brokers and traders of a broker-dealer related to the Fund who are Series 7 registered.
  • Financial, compliance, operational and accounting officers of a fund who have management responsibilities for compliance, accounting and auditing functions of funds.

The SEC also said that research analysts who investigate the potential investments for the fund may not be knowledgeable employees unless they research all potential portfolio investments and provide recommendations to the portfolio manager.

Sources:

Photo is of the Board of Directors and Officers of the Industrial Exhibition Association of Toronto 1930 used under Creative Commons License from the Toronto Public Library Special Collections

Compliance, Van Halen and Brown M&M’s

You may have heard the story about Van Halen’s banning of brown M&M’s from its dressing room. I chalked it up to the pampered life of rock stars. (Especially, when compared to the more mundane life of a chief compliance officer.)

I just listened to the latest episode of  This American Life which revealed that the provision was not about pampering. It was about compliance.  Host Ira Glass talked with John Flansburgh (from the band They Might Be Giants) and he explained why the M&M clause was actually an ingenious business strategy. They recounted an except from David Lee Roth’s autobiography, Crazy from the Heat:

Van Halen was the first band to take huge productions into tertiary, third-level markets. We’d pull up with nine eighteen-wheeler trucks, full of gear, where the standard was three trucks, max. And there were many, many technical errors — whether it was the girders couldn’t support the weight, or the flooring would sink in, or the doors weren’t big enough to move the gear through.The contract rider read like a version of the Chinese Yellow Pages because there was so much equipment, and so many human beings to make it function. So just as a little test, in the technical aspect of the rider, it would say “Article 148: There will be fifteen amperage voltage sockets at twenty-foot spaces, evenly, providing nineteen amperes . . .” This kind of thing. And article number 126, in the middle of nowhere, was: “There will be no brown M&M’s in the backstage area, upon pain of forfeiture of the show, with full compensation.”

So, when I would walk backstage, if I saw a brown M&M in that bowl . . . well, line-check the entire production. Guaranteed you’re going to arrive at a technical error. They didn’t read the contract. Guaranteed you’d run into a problem. Sometimes it would threaten to just destroy the whole show. Something like, literally, life-threatening.

Van Halen used the candy as a warning flag for an indication that something may be wrong. I see some lessons to be learned.

Update:

Diamond Dave talking about Brown M&Ms.

Brown M&Ms from Van Halen on Vimeo.

(via NPR Music’s The Record: The Truth About Van Halen And Those Brown M&Ms by Jacob Ganz

References:

Corporate Compliance Fraud in Georgia, Florida and Massachusetts

Just like the Corporate Compliance Fraud in Ohio, Compliance Services is also targeting companies in Georgia, Florida and Massachusetts.

The Daily Citizen is reporting Georgia corporations warned about solicitations. The Georgia Secretary of State issued a warning:

“Several corporations registered with the Corporations Division of the Office of the Secretary of State received a letter from Georgia Corporate Compliance, a private company offering to complete corporation meeting minutes on behalf of registered corporations.”

The Attorney General of Florida also issued a warning:

Over the past several months, the Attorney General’s Office has received numerous complaints against several of these companies. Last week the Attorney General settled a lawsuit against one such company, Corporate Compliance Center, over allegations that the company misled Florida businesses relating to the sale of corporate minutes reports. Two other companies, Corporate Minutes Compliance Service and Corporate Minute Services, were prevented from operating in Florida when the Attorney General’s Office threatened litigation.

Bill Galvin, the Secretary of the Commonwealth of Massachusetts issued his warning:

Recently, an entity calling itself “Compliance Services” mailed solicitations entitled “Annual Minutes Requirement Statement Directors and Shareholders” to numerous Massachusetts corporations. This solicitation offers to complete corporate meeting minutes on behalf of the corporation for a fee. Despite the implications contained in the solicitation, Massachusetts corporations are not required by law to file corporate minutes with the Secretary of State.

Thanks to Corporate Compliance Insights: Compliance Scam Alert in Georgia: Corporate Minutes Hoax Not Limited to Ohio.

See also: