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Changes in store for alternative-investment firms; Investors worry financial-reform bill will hurt innovation

September 6, 2010

By Arleen Jacobius

Financial reform will have a significant impact on how the alternative-investment management business is conducted.

While specific rules have yet to be set, the reforms called for in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 could affect everything from investment returns to leverage and risk-taking to innovation and transparency of private-equity, real estate and hedge fund managers.

"This will change the way alternative-investment businesses are run. They will have to use more capital and less leverage, and less risk-taking," said Henry Kahn, a partner in law firm Hogan Lovells.

Big financial services firms will have to decide what lines of alternatives businesses they will retain and how they will be structured. Smaller firms might have to deal with Securities and Exchange Commission registration, giving the world - and regulators - a peek at their investment strategies.

"This fundamentally changes what types of businesses financial services firms are in," Mr. Kahn said.

Institutional investors worry that registration with the SEC could inhibit investment innovation by midsize private-equity, real estate and hedge fund managers, Mr. Kahn said. Many larger alternatives firms already are registered and it is yet to be seen whether the real estate investment managers will be exempt from the requirement.

"Some large institutional clients are concerned that regulations will put additional costs on medium-size advisers and inhibit beneficial innovation in investing," Mr. Kahn said.

Investors also worry that more transparency and heightened inspection by the SEC will make managers less willing to innovate because their proprietary strategy will be open to review by the SEC and competitors.

Martin Cohen, co-chairman and chief executive of the real estate investment firm Cohen & Steers Inc., agrees that financial reform is having a major impact, with financial institutions divesting themselves of private-equity and real estate businesses.

For example, Bank of AmericaMerrill Lynch effectively abandoned the business when it outsourced management of its Asian real estate fund to The Blackstone Group LP in July, said Steven Coyle, chief investment officer of Cohen & Steers' fund-of-funds management arm, Global Realty Partners.

Anticipating that financial reform is likely to make the businesses obsolete was one reason leading to the decision to sell, Mr. Coyle noted. The other was "realizing that recent hits to real estate made these businesses less attractive," he said.

Bank of America executives could not be reached for comment.

"If they remain as banks, I don't think they will stay in business," Mr. Coyle said. "Most investors invested because the house [the bank parent of the investment management firm] had a major investment."

BACKING OFF BIG FIRMS

Large non-bank financial institutions may also suffer if investors start to shy away from large investment firms. While "this is not the death knell of large firms," Mr. Coyle said, on balance, investors will move toward a smaller operating model.

Most investment firms are still studying the impact of financial reform on their portfolios.

"CalSTRS executives are looking at the impacts the financial-reform-legislation package will have on all our asset classes, including real estate, private equity and hedge funds. The landscape is shifting and CalSTRS has been involved in providing input in some instances," Ricardo Duran, a spokesman for the $129.7 billion California State Teachers' Retirement System, wrote in an e-mail. "However, it is still too early to tell just how dramatic an impact this complex legislation will have on the financial system."

Financial reforms in the U.S. and globally are expected to have the effect of making debt, a key ingredient in real estate and private-equity investments, even harder to come by.

"There is a concern that, whereas normalcy would return to the debt capital markets, the derisking [caused by the financial reform law] will cause debt capital markets for real estate to be slower to recover," said Robert T. O'Brien, the real estate leader for Deloitte Consulting LLP. "Lending standards will be tighter with more documents, more diligence and with banks having to have more capital reserves."

This will be the case for private equity investment managers as well, he added.

Anthony Orso, the executive managing director and chief executive of Cantor Commercial Real Estate, expects new rules forcing banks to own a portion of the securities they are selling "will make financial institutions less likely to want to originate loans."

Cantor Commercial Real Estate was formed earlier this month by Cantor Fitzgerald LLP and the real estate investment firm CIM Group Inc. to offer real estate and mezzanine loans, which the group intends to securitize into commercial mortgage-backed securities.

Additional financial regulations "will make it harder and harder for banks to compete," Mr. Orso said when he announced the firm's formation.

The reforms "will affect banks, but not specialty real estate finance companies such as CCRE," he wrote in an e-mail.

Matt Khourie, chief executive of CB Richard Ellis Investors LLC, expects financial reform to have a big impact on the real estate industry because "some of our biggest competitors are owned by financial institutions."

Some of these competitors may not be able to stay in business long-term, he said.

"It's causing a shuffling of the deck in our industry," Mr. Khourie said. "Those not committed long-term will be looking to reduce their exposure or get out of the business. All that causes uncertainty with employees and their investor bases."

Mr. Khourie said he expects to see major changes in the business over the next 12 to 18 months as some of the firms with the biggest funds in the industry reconsider their positions.

OTHER SHOE

Now that the Dodd-Frank bill has been signed into law, institutional investors and managers are waiting for the other shoe to drop: that is, the regulatory specifics.

One little discussed aspect of the so-called Volcker Rule - which restricts banks from proprietary trading - is that it also prohibits financial institutions from owning more than 3% of any alternative investment fund.

"Banks cannot buy 3% of a private-equity [investment] or a hedge fund, and banks cannot sponsor or operate a fund and invest more than 3%," said David Sahr, a partner in the financial services, regulation and enforcement division at the law firm Mayer Brown LLP.

This not only applies to funds being raised, but also to any funds - private equity, real estate and hedge funds - the financial institutions now sponsor, said Lennine Occhino, a partner at Mayer Brown.

More widely discussed has been the aspect of the Volcker Rule that requires banks to hold no more than 3% of Tier 1 capital in its total private-equity and hedge fund exposure. Tier 1 is a bank's cushion of core capital intended to absorb losses so that deposits will not be endangered, Mr. Sahr said. What's more, a bank must have a fiduciary relationship with investors and have an existing asset management relationship with investors to sponsor alternative-investment funds at all, he said.

A number of large Wall Street firms have indicated they are affected by the law, which affects any financial institution that has a depository business or services, Ms. Occhino said, declining to identify the firms.

Foreign banks and their affiliates are also covered, even if they do not have depository businesses in the U.S., Mr. Sahr said.

But the rules do not stop there. Even if a financial institution does not own a bank, if the institution is so important to the U.S. economy that it could cause a systemic breakdown, it could be subject to supervision by the Federal Reserve, he said.

Those institutions could include large insurance companies, large private-equity and hedge fund firms, large manufacturers or their investment management subsidiaries such as General Electric Co.'s GE Capital. These firms would not be prohibited from owning and sponsoring alternative-investment funds, but they would be subject to overall capital limits that have yet to be set by the Federal Reserve, Mr. Sahr said.

"The legislation gives the Federal Reserve the authority to designate non-banks as systemically important financial institutions," Mr. Kahn said.

BAILING ON BUSINESSES

Federal reform could give financial services firms an excuse to jettison alternative-investment portfolios, such as private equity and real estate, that are suffering the aftereffects of investments made during the wild and crazy pre-crisis days, sources said.

Some banks already have discussed selling off real estate, hedge fund and private equity investment management businesses. Executives at ING Groep NA, Bank of America Corp., The Goldman Sachs Group Inc. and Morgan Stanley are all reportedly having those discussions.

"I'm surprised with discussions already happening in the market," Mr. O'Brien said. "People are strategically evaluating their businesses almost as we speak," even though regulations are yet to come and compliance set for years in the future.

At the same time, some private investment firms see this as an opportunity to expand their businesses. Many expect to scoop up talented investment executives from large financial services firms or acquire existing investment management units from players departing the business, Mr. O'Brien said.

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