Demands from regulators and investors are increasing the cost burden for managers just as they are coming under pressure to cut fees and minimise fixed costs. John Forbes reports
The world of real estate investment management has changed significantly. For many investors, the traditional blind-pool closed-ended fund is out of favour as club deals and joint ventures come into fashion. This however, only caters for part of the market and new real estate funds will need to be attractive to the smaller investors that do not have the scale to join with the bigger players. The demands for governance and transparency that the larger institutions are making are equally important in providing the assurance that other investors need to return to the fund market.
Tax planning traditionally was often the key driver of fund structuring. Fund managers will have to deal with a broader range of issues in the future. Tax will clearly remain a major consideration in structuring funds, deals and the new managed accounts. Moreover, the robust challenges to tax planning by the relevant authorities around the world will require a much greater attention to detail in structuring and a more rigorous ongoing risk management process. In particular, tax authorities are more focused on the commercial substance behind transactions and also in looking at whether entities are tax resident where they claim to be. New legislation, such as the US Foreign Account Tax Compliance Act (FATCA) that comes fully into effect in 2013, will also increase the reporting burden for real estate funds.
It is not only in respect of tax that the burden is becoming greater. Regulation will be a major consideration in the future. Most obvious is the impending EU Alternative Investment Fund Managers (AIFM) directive that lays down the rules for alternative investment funds managers, including real estate fund managers. The directive establishes the framework for the authorisation, operation and transparency of AIFMs that manage and/or market such funds in the EU. This took a significant step forward on 19 October with the news that The Economic and Financial Affairs Council (ECOFIN) had agreed to a text to be put before the European Parliament. And this is not the only regulatory change on the horizon.
Managers with US investors in their funds might also find themselves caught by the requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Those that are caught face a requirement to register with the US SEC by next summer. Once registered, the fund manager will need to comply with filing requirements. For many non-US investment managers, this will be an additional burden. Another aspect of the Act is that the ‘Volcker Rule' of the new law will prohibit banking entities from taking anything other than the minimum stakes in real estate private equity funds. A bank is allowed an interest in a fund that it organises or offers subject to a cap of no more than 3% of the total ownership interest in the fund and the aggregate of all such investments being limited to 3% of the entity's tier-1 capital.
Although there is a general rule that no director or employee of the banking entity may hold an interest in a fund organised or offered by the firm, there is an exception for any director or employee who is directly engaged in providing investment advisory or other services to the fund. The implementing regulations have not yet been drafted so there is some uncertainty as to how this will apply in practice. The same applies to the remuneration provisions in the AIFM directive. This is important as a key concern of investors is to ensure that manager interests are aligned with theirs through reward and co-investment.
Although the burden of tax and regulatory reporting is significant, the greater push in terms of reporting will come from investors. For investors performance has historically been the key differentiating factor between fund managers; governance, risk and controls were rarely considered. This has changed; investors are now concerned with transparency and corporate governance. Fund managers face higher costs in satisfying investor demand for information during due diligence.
There are also the first signs of demand for third-party verification through the use of independently verified controls reporting, such as Statement on auditing Standards (SAS) 70 type documents or independent attestation of fund performance track records used in fund-raising. While many traditional asset managers have been required to demonstrate the effectiveness of their internal controls by providing independently audited reports to institutional investors for many years, real estate fund managers have not faced the same pressure.
The greater pressure for transparency and reporting from investors, regulators and tax authorities creates a double-whammy for real estate fund managers. First, this is happening at the same time as fund managers face downward pressure from investors on fees. Those fund managers that are unable to resist the demand to cut fees will find it increasingly difficult to make ends meet in what will now be a higher-cost environment. Second, the pressure on fund managers to minimise fixed costs and to operate a leaner model is also occurring when investors are become less tolerant of reporting and compliance failure. Cutting corners to make ends meet is likely to be more severely punished by the authorities and ultimately by investors.
For real estate fund managers, the next few years will be tough.