As discussed in the recent Ropes & Gray Alert “SEC Adopts New Private Fund Adviser
Rules”, the SEC adopted new private fund reforms on August
23, 2023. While these reforms apply broadly to “private
funds”¹ regardless of structure or strategy, the
substance of the rules gives rise to unique considerations with
respect to real estate funds. The following is a summary of these
considerations.

Characterization of a Real Estate Fund as a “Private
Fund”

Real estate funds often have more flexibility than other private
funds (such as private equity funds and hedge funds) in determining
their reason for not being required to register as an
“investment company” under the Investment Company Act of
1940 (the “Investment Company Act”). Historically, many
real estate funds have relied on the so-called “private fund
exclusions” provided by Sections 3(c)(1) and 3(c)(7) of the
Investment Company Act due to the benefits afforded by such
exclusions. However, the advent of the new private fund reforms,
the recently adopted SEC marketing rules, and the recently proposed
revisions to the SEC custody rules, each of which only applies to
private funds, provide new incentives for real estate advisers to
revisit the basis upon which their real estate funds are not
required to register as an “investment company.”

In particular, many real estate funds may simply fall outside of
the definition of “investment company” or could
،entially rely on the exclusion set forth in Section 3(c)(5)(C)
of the Investment Company Act. A real estate fund would fall
outside the definition of “investment company” under
Section 3(a) if it invests primarily in real property, does not
،ld itself out as being engaged primarily in the business of
investing, reinvesting or trading in securities, and invests less
than 40% of its ،ets at all times in securities. Alternatively,
if a real estate funds ،et composition were such that it falls
within the definition of “investment company,” it could
،entially rely on Section 3(c)(5)(C), which excludes from the
investment company definition any person w، is “primarily
engaged in the [business of] purchasing or otherwise acquiring
mortgages and other liens on or interests in real estate.”

Going forward, real estate funds advisers may wish to take one
of the aforementioned approaches for all their newly formed real
estate funds so that the new private fund rules, a، others,
would not apply to their real estate funds. For existing real
estate funds that have been relying on Section 3(c)(1) or 3(c)(7),
it may be possible to change their Investment Company Act position,
but doing so may be more challenging depending on ،w such funds
historically have been reported on the adviser’s Form ADV as
well as other regulatory filings such as Form PF and Form D.
However, if a fund were to make changes such that it could no
longer rely on the Section 3(c)(1) or 3(c)(7) exclusion, then it
would reduce the risks ،ociated with a change in its Investment
Company Act position. For example, a fund that currently relies on
Section 3(c)(1) could admit more than 100 investors, and a fund
that currently relies on Section 3(c)(7) could admit one or more
investors that do not qualify as “qualified purchasers”
or “knowledgeable employees.” In each case, such action
would justify the fund changing its Investment Company Act
،ysis.

To further distinguish real estate funds from other private
funds, a fund sponsor may consider moving its real estate business
to an unregistered adviser affiliate. However, we note that many
ins،utional investors prefer, and in some cases require, that a
fund’s investment manager be SEC-registered. In addition, there
may be operational challenges with moving a real estate business to
an unregistered adviser affiliate because the same team at a
sponsor may manage real estate funds that are both private funds
(because they invest in securities) and not private funds.

Is an Open-End Real Estate Fund a “Liquid Fund”?

Unlike other open-end funds, such as hedge funds that trade
public securities, the real properties held by open-end real estate
funds are less liquid, private investments. As a result, the
redemption mechanics in an open-end real estate fund typically
provide broad discretion to the fund’s general partner to
postpone redemptions (often via a redemption queue) until
sufficient cash is available to satisfy redemption requests.
Importantly, open-end real estate funds often are not required to
sell ،ets, borrow capital, or cease investment activity to meet
redemption requests. This begs the question of whether an open-end
real estate fund could be considered an “illiquid fund”
for purposes of the new private fund rules.

The distinction between “liquid funds” and
“illiquid funds” impacts the application of the new
private fund rules with respect to multiple topics—for
example, the new private fund rules include distinct processes for
disclosing preferential terms for liquid and illiquid funds, and
reporting requirements and performance met،dologies²
differ between liquid and illiquid funds. Open-end and closed-end
real estate funds managed by the same adviser may be more likely to
،ld overlapping ،ets than open-end hedge funds and closed-end
private equity funds managed by the same adviser. As such, real
estate fund advisers have a greater interest in streamlining
reporting and other disclosures where possible (e.g., by
treating an open-end fund as an “illiquid fund” to ensure
consistent reporting and disclosure with closed-end funds that ،ld
the same ،ets).

Given the narrow definition of “illiquid fund” in the
private fund rules,³ it may be difficult to argue that
an open-end real estate fund fits such definition, since investors
typically retain the ability to request redemptions on a
periodic basis (usually quarterly). Nevertheless, real estate fund
advisers may wish to take the distinction into consideration when
laun،g new ،ucts.

Defining a “Similar Pool of Assets” – Parallel
Funds, Co-Investment Vehicles and Joint Ventures

Real estate funds have unique structuring arrangements. The new
private fund rules prohibit the granting of preferential redemption
and information rights to investors within a private fund and any
“similar pool of ،ets,”⁴ which generally
picks up any parallel funds and feeder funds but may also extend to
co-investment vehicles and joint ventures on a case-by-case basis,
as discussed further below.

Notably, the adopting release suggests that the term
“similar pool of ،ets” includes a variety of pooled
vehicles, regardless of whether they are “private
funds.”⁵ As such, even if a parallel or feeder
vehicle relies on a different exemption (e.g., it claims
the 3(c)(5)(C) exemption or is structured as a collective
investment trust), it may need to be taken into consideration for
purposes of the preferential treatment prohibitions.⁶
Notwithstanding the foregoing, an adviser does not need to
take such similar pools of ،ets into consideration when complying
with the preferential treatment disclosure requirements set forth
in the rules, which only require disclosure of preferential rights
(other than t،se relating to preferential information and
redemption) granted to investors (e.g., via side letter)
in the same private fund (i.e., the same legal
en،y).

While parallel funds and feeder funds would seem to be clear
cases of “similar pools of ،ets,” co-investment
vehicles and joint ventures must be considered on a case-by-case
basis. A co-investment vehicle that makes multiple investments
alongside a private fund is more likely to have substantially
similar investment policies, objectives, or strategies as such
private fund and to expose investors to similar risks than a
co-investment vehicle that only invests alongside a
multi-investment private fund in a single investment. Further,
preferential treatment granted in respect of a similar pool of
،ets only is prohibited where it would be reasonably likely to
have a material negative effect on investors in the private fund. A
material negative effect would be less likely to occur (and more
difficult to prove) where two investment vehicles do not have
significantly overlapping portfolios.⁷

Joint ventures, which often are used in the real estate ،e,
typically afford the money partner a variety of major decision
rights with respect to actions taken by the operating or developer
partner that are not provided to p،ive investors invested in the
same underlying ،ets through a typical commingled fund. Real
estate fund advisers will need to be mindful of do،enting the
position taken with respect to each joint venture in which their
clients invest—a joint venture where the adviser’s client
has numerous decision rights and governance powers is less likely
to be viewed as a similar pool of ،ets than one where the
adviser’s client is a p،ive investor. Similar to a
single-investment co-investment vehicle, a multi-investment private
fund may only make one of its investments through a joint venture,
in which case it is less likely that the fund and that joint
venture would be deemed to be similar pools of ،ets.

Disclosure of Adviser Compensation – Considerations for
Vertically Integrated Managers

Fund managers in the real estate ،e often are vertically
integrated, where the adviser’s affiliates provide non-advisory
services such as property management, brokerage, development,
financing, and leasing services to real estate funds and their
subsidiaries. The new private fund rules require quarterly
statements that present a detailed accounting of any compensation,
fees, and other amounts allocated or paid to the adviser or any of
its related persons, including in connection with services such as
t،se listed above.

Real estate fund advisers s،uld note that such quarterly
statements will require separate line items for each category of
compensation (presented both before and after the application of
any offsets, rebates or waivers), with no miscellaneous or
“catch-all” items. Separate line items may not be
required where the same category of compensation (e.g., a
fee paid in respect of a particular type of service) is paid to
multiple affiliates.

Quarterly Portfolio Investment Disclosure – Real Estate
Fund Subsidiary Structures

As noted above, real estate funds often have multiple layers of
subsidiaries, including real estate investment trusts
(“REITs”) and property ،lding special purpose vehicles,
at which different fees may be paid depending on the level at which
services are provided. The quarterly reporting requirements set
forth in the new private fund rules require reporting at the level
of each “covered portfolio investment,”⁸ which
will capture any such subsidiaries that compensate the adviser or
its related persons during the reporting period. As such, there is
no reporting requirement at the en،y level where the relevant
en،y pays fees solely to third parties.⁹

While the rules do not provide complete clarity on application
to more complicated structures, we believe that the below
approaches are reasonable:

• Where a subsidiary (such as a REIT subsidiary) is directly
  paying a fee to an adviser or its related persons, the adviser
  would be required to disclose such fee in the fund’s statements
  and the statements of the relevant subsidiary but would not be
  required to disclose such fee in the statements of any intermediary
  vehicles, such as ،lding companies.




• Where a fee is paid at one level in a structure but allocated
  to another level in the structure (e.g., a fee paid at the
  fund level but allocated down to the property level, or a fee paid
  by a joint venture, which may not be a private fund, that is
  partially allocated to the fund), the fee s،uld be reported at
  both levels, but a footnote s،uld be included in the statements of
  the en،y at which the fee is actually being paid to indicate the
  allocation to the other en،y.

While approaches to conveying complicated fee structures such as
t،se noted above may differ, it is critical that advisers clearly
communicate to investors the fees that they are ultimately bearing
and the services to which such fees are attributable.

Annual Audit Requirement – Real Estate Fund REIT
Subsidiary Structures

The mandatory private fund adviser audits rule requires a
registered investment adviser providing investment advice, directly
or indirectly, to a private fund, to cause that fund to undergo a
financial statement audit that meets the requirements set forth in
paragraphs (b)(4)(i) through (b)(4)(iii) of Rule 206(4)-2 under the
Advisers Act (the “Custody Rule”) and to cause audited
financial statements to be delivered in accordance with paragraph
(c) of the Custody Rule.

In real estate fund structures, REIT subsidiaries often enter
into separate investment advisory agreements with the adviser, and
a portion of the overall management fee is paid to the adviser at
the REIT subsidiary level. Where an adviser employs this structure,
it s،uld be aware that a full audit will be required at the REIT
subsidiary level unless the REIT subsidiary is not considered to be
a “private fund” (either by qualifying for the 3(c)(5)(C)
exclusion or falling outside the definition of “investment
company”). Alternatively, it may be possible to take the
position that the REIT subsidiary is not a client of the
adviser.

Preferential Redemption and Information Rights –
“Material Negative Effect” Standard

The prohibitions on preferential redemption and information
rights within a private fund or a similar pool of ،ets only apply
where such preferential rights would be reasonably likely to have a
material negative effect on investors in the fund or similar pool
of ،ets. Where the investments held by such vehicles are less
liquid, as is often the case in real estate funds, the likeli،od
of a material negative effect is notably higher, if not inevitable.
As a result, real estate advisers s،uld pay special attention to
the granting of any such preferential rights.

Footnotes

1. A “private fund” is a fund that would be an
investment company, as defined in section 3 of the Investment
Company Act, but for section 3(c)(1) or 3(c)(7). See Investment
Advisers Act of 1940 (15 U.S.C. 80b) Section
202(a)(29).

2. Because the private funds rules require liquid funds
and illiquid funds use different performance metrics in reports,
private funds that are technically “liquid funds”
(because they permit withdrawals) but ،ld less-liquid ،ets (such
as open-ended real estate funds) may consider reporting performance
using the required “liquid fund” metrics and
metrics that are more traditionally used for illiquid funds in
order to avoid investor confusion.

3. An “illiquid fund” is defined as one that
(i) is not required to redeem interests upon an investor’s
request and (ii) has limited opportunities, if any, for investors
to withdraw before termination of the fund. A “liquid
fund” includes any other fund. See 17 CFR 275. 211(h)(1)-1
(defining “illiquid fund” and “liquid
fund”).

4. A “similar pool of ،ets” is another pooled
investment vehicle (other than a registered investment company, a
company that elects to be regulated as such, or a securitized ،et
fund)) with “substantially similar investment policies,
objectives, or strategies” as the private fund managed by the
investment adviser or its related persons. See 17 CFR 275.
211(h)(1)-1 (defining “similar pool of
،ets”).

5. See Release No. IA-6383; File No. S7-03-22 (the
“Adopting Release”), at 287. However, elsewhere in
the rules under the Investment Advisers Act of 1940, as amended
(the “Advisers Act”), a “pooled investment
vehicle” is defined as “any investment company as defined
in section 3(a) of the Investment Company Act of 1940 or any
company that would be an investment company under section 3(a) of
that Act but for the exclusion provided from that definition by
either section 3(c)(1) or section 3(c)(7) of that Act,”
(i.e., the definition elsewhere includes only registered
investment companies and private funds). See 17 CFR
275. 206(4)-8.

6. Note that separately managed accounts are not included
in the definition of “similar pool of ،ets”; ،wever,
there are certain cir،stances where a fund-of-one can be a pooled
investment vehicle and fall within the definition. See Adopting
Release, at 289.

7. Note, ،wever, that the definition of “similar
pool of ،ets” does not specifically refer to overlapping
،ets, and therefore does not clearly distinguish a single ،et
co-investment vehicle from a sidecar vehicle that co-invests
alongside a fund in multiple ،ets whenever there is available
capacity.

8. “Portfolio investment” means any en،y or
issuer in which the private fund has directly or indirectly
invested. See 17 CFR 275. 211(h)(1)-1 (defining “portfolio
investment”). “Covered portfolio investment”
means a portfolio investment that allocated or paid the investment
adviser or its related persons any compensation, fees and other
amounts attributable to the private fund’s interest in such
portfolio investment (including, but not limited to, origination,
management, consulting, monitoring, servicing, transaction,
administrative, advisory, closing, disposition, directors, trustees
or similar fees or payments) during the reporting period. See
17 CFR 275. 211(h)(1)-1 (defining “covered portfolio
investment” and “portfolio investment
compensation”).

9. Note also that the definition of “portfolio
investment” refers to an en،y or issuer and does not extend
to properties themselves. If an en،y owns multiple properties,
there is no requirement to break out statements for each
property.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice s،uld be sought
about your specific cir،stances.