The Custody Rule is a well intentioned beast of regulation designed to prevent investment advisers from stealing money from their clients. The Rule works well for retail investment advisers and most hedge funds. It starts falling apart for private equity funds and real estate funds. The Securities and Exchange Commission tried providing some additional guidance in June with its IM Guidance Update 2014-07. Unfortunately, I think the guidance only made it more confusing for funds trying to comply with the rule and the examiners trying to do their jobs in the field.
The problem with the Guidance was Scenario 4 when a fund invests in another investment vehicle. Unlike the three previous scenarios in the Guidance, this clearly is not an SPV. The investmentvehicle could be another fund, a joint venture or co-investment. The Guidance reaches the conclusion that the fund manager should get audited financial statements for the investment vehicle to comply withe custody rule because it is a separate advisory client.
Many people skip over footnote 10 that states that the SEC assumes that the SPVs in the four scenarios are investment advisory clients. But in many situations, that investment vehicle may not be an investment advisory client. The assumption in footnote 10 drives you directly to the conclusion.
The Guidance also makes the mistake of stating that compliance with the Custody Rule can only be be achieved through providing audited financial statements. A fund manager can use the standard Custody Rule method of having information sent directly to investors by a third-party custodian.
Getting back to the headline, one question for real estate funds has been what to do with REIT subsidiaries in the fund structure. This was also an issue pre-Dodd-Frank in deciding whether to include them as clients in determining whether you had reached the old 15-client threshold.
The subsidiary REITs could fit into the bucket of scenario 4. The fund is an investor in the subsidiary REIT and there are third party owners in the REIT. One of the requirement of REIT status is that you must have at least 100 shareholders. Since it’s a subsidiary, the fund manager is focused on its interest and typically uses accommodation shareholders to fill in the other 99 slots. I remember in my early years of practice that REITs would round up lawyers, accountants, family and friends to fill in the empty slots. Now, third party vendors will fill up those slots.
Those 100 accommodation shareholders get a preferred return paid to them, but have no interest in the ultimate economics of the REIT subsidiary. The accommodation shareholders collect their annual payment but have no concerns about investment performance. The current market rate is about 12% on their $1000 investment. They get their $120 a year and then the $1000 back at the end of the fund life.
In speaking with a group of real estate fund CCOs we discussed what their approach is for subsidiary REITs under the Custody Rule. We were startled to learn that the SEC had recently issued a deficiency letter to another real estate fund manager during an SEC exam for failing to issue audited financial statements for the REIT subsidiaries. From a redacted copy of the deficiency letter:
“This guidance [IM Guidance Update 2014-07] does not contemplate whether a client pays fees to the investment adviser, because entities are not required to pay advisory fees in order to be considered investment advisory clients. Accordingly, this guidance indicates that Registrant must distribute the audited financial statements of all pass-through entities or special purpose vehicles that are controlled by Registrant or a related person and have outside investors to each such entity’s beneficial owners.”
I think this is a shocking overreach by those SEC examiners. They seem to skip right over Footnote 10 and its assumption for purposes of the guidance that the investment vehicle, in this case the subsidiary REITs, are advisory clients.
I would be interested to hear what other real estate fund managers are doing with their REIT subsidiaries for the Custody Rule. You can email me directly at my office or at [email protected].
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