Providers of financial services, such as prime brokers, are now calibrating how to respond to the Dodd-Frank Wall Street Reform and Consumer Protection Act. Under review are the Act’s effects on returns, leverage, risk-taking, innovation, and transparency. That is because the Act drives higher margin requirements and less leverage. Providers also worry that the threat of increased SEC scrutiny will inhibit certain proprietary strategies favored by hedge funds and other alternative investments.
Private equity and real estate funds are also feeling the heat. For example, Bank of America Merrill Lynch effectively departed the business when it outsourced management of its Asian real estate fund to Blackstone Group in July, said Steven Coyle, chief investment officer of Cohen & Steers’ fund-of-funds management arm, Global Realty Partners, New York.
Anticipating that financial reform would likely 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 on an ongoing basis,” he said. “If they remain as banks, I don’t think they will stay in business,” Mr. Coyle said. “Most investors invested because the house (bank parent to the investment management firm) had a major investment.”
Large non-bank financial institutions may also suffer as investors start to shy away from large investment firms. While “this is not the death knell of large firms,” he said, on balance, investors will move toward a smaller operating model, Mr. Coyle added.
Financial reforms — both in the U.S. and globally — are expected to have the combined 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 de-risking (caused by the financial reform law) will cause debt capital markets for real estate to be slower to recover,” said Robert T. O’Brien, real estate leader for New York-based consulting firm Deloitte. “Lending standards will be tighter with more documents, more diligence and with banks having to have more capital reserves.”
With the financial overhaul signed into law, institutional investors and managers now 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 owning more than 3% of any alternative investment fund.
“Banks cannot buy 3% of a private equity or hedge fund and banks cannot sponsor or operate a fund and invest more than 3%,” said David Sahr, partner in the financial services, regulation and enforcement division at the New York office of 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, partner in the Chicago headquarters of Mayer Brown.
More widely discussed has been the aspect of the Volcker Rule that banks’ total private equity and hedge fund exposure must not be more than 3% of Tier One capital — banks’ cushion of core capital intended to absorb losses so they won’t cut into deposits, 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, 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 the economy to break down, it could be subject to supervision by the Federal Reserve, he said.
These could include large insurance companies, large private equity and hedge fund firms, large manufacturers or their investment management subsidiaries like 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.
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, he said.
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