'Volcker Rule' Would Shift Fund Landscape

The financial reform legislation before Congress could force three of the largest operators of U.S. real estate funds out of the business, but changes would likely unfold slowly.

The sweeping bills approved by the House and Senate both contain provisions that prohibit affiliates of FDIC-insured banks from sponsoring and investing in hedge funds and private equity funds, including ones that focus on real estate.

As House and Senate conferees worked to hammer out differences in the bills this week, bank lobbyists waged a last-ditch effort to water down the fund curb, which is part of the so-called Volcker Rule, proposed by former Federal Reserve chairman Paul Volcker. There were signs that the banks and their allies on Capitol Hill were having some success in those efforts. But the fate of some of the largest sponsors of real estate funds remained up in the air.

Affiliates of 11 FDIC-insured banks either operate open-end funds or have set up closed-end vehicles over the past five years, according to Real Estate Alert's Fund Database. The sponsors have operated 53 funds with $76.6 billion of aggregate equity since 2005 (see accompanying table). But three shops accounted for three-quarters of the capital raised - Morgan Stanley, Goldman Sachs and J.P. Morgan.

Even if adopted as is, the legislation would give banks as much as six years to divest funds. So changes wouldn't occur overnight. The life cycles of many existing funds would run out during that period, so the current operators could wind them down.

But some giant vehicles would be put up for grabs, such as J.P. Morgan's $9.7 billion Strategic Property Fund - the largest open-end fund. And bank sponsors, if they launched any additional funds at all, would presumably be limited to relatively small, short-term vehicles.

The proposed legislation comes at a time when the fund industry is already in upheaval because of losses suffered in the market downturn. Two of the 11 bank sponsors - Citigroup and Dutch conglomerate ING - were already moving to exit the sector. And several of the others are relatively small operators. But the Volcker Rule, as currently envisioned, would eliminate a whole category of fund operator and would block other banks from entering or returning to the sector.

Market pros said there would be plenty of nonbank operators interested in buying fund-management rights if banks were forced to sell. Citi and the bankrupt Lehman Brothers recently had no trouble finding buyers for funds they operated. Apollo Global, the New York buyout firm, agreed to take control of Citigroup's Citi Property Investors funds. And PCCP, an investment manager in El Segundo, Calif., acquired the management rights to two Lehman mezzanine-loan funds.

The legislation would likely have a big impact on personnel. With no prospect of launching new vehicles, fund pros would be tempted to jump ship quickly, especially if their current vehicles were so far underwater from the market downturn that there was little hope of getting a profit split.

"If you are sitting at these firms, and you know they are never going to raise another fund, and the carry isn't worth anything, why would you stick around?" asked one veteran equity-raising specialist.

Likewise, banks would probably quickly downsize internal placement units - even if those groups raised capital for other fund shops.

Some fund teams would likely join forces with deep-pocketed investors to buy out the management rights from their employers.

One possible concession by legislators would be to permit banks to sponsor funds provided that they not invest any of their own capital. But limited partners generally insist that sponsors have "some skin in the game," and such a prohibition would likely cripple operators' ability to attract outside capital, market pros said.

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