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The Trickle-Down Effect of Sarbanes-Oxley

Real estate private equity funds are finding themselves in an overly regulated, ever-changing and immensely complex climate when it comes to financial reporting and accounting issues.

Traditionally, real estate private equity funds have discreetly reported their investment results. This discretion — plus ambiguous accounting rules — has resulted in a lack of consistency in the financial reporting of these funds.

That just doesn't work in today's post-Enron world. Investors now demand greater transparency and standardization in the reporting of their investments and related earnings of these funds.

A real estate private equity fund is defined as a legal entity — typically a partnership or a limited liability company — that raises capital from high net-worth individuals, pension funds and other institutional players. The proceeds are then invested in real estate. Since the early 1990s, these funds have increased by more than $100 billion, and taken together with publicly traded REITs they are arguably the biggest worldwide source of capital for real estate investments.

Since the Sarbanes-Oxley Act was passed in 2002, the financial reporting rules relating to real estate private equity funds have become extremely complex. The act is the most significant change to securities law, accounting fundamentals and financial reporting since the 1930s. Among its many provisions, it created the Public Company Accounting Oversight Board (PCAOB), which governs the accounting industry and requires audited internal controls over financial reporting for public companies.

The passage of the act has spurred many structural changes within the accounting profession as well as many new accounting rules. Sarbanes-Oxley not only had a direct impact on publicly traded companies, but the spillover effects of the new law also have impacted the financial reporting methods of private equity funds. The structure of a fund's reporting methods, as well as its ability to raise capital from institutional investors, must now be reviewed in a whole new way.

To be sure, current accounting rules — with respect to Generally Accepted Accounting Principles (GAAP) reporting for real estate private equity funds — are ambiguous. Although most funds report audited results using the fair value method, many others report audited GAAP results under the historical cost method. The inconsistency between the application of these accounting rules and the varieties of current practice can be confusing to both fund managers as well as real estate investors.

How Far Will Funds Go to Comply?

During a recent transaction between a real estate private equity fund and a large public company, the company leased several large buildings from the fund at above-market lease rates. The economics of the lease made it desirable for the company to buy the properties directly from the fund.

But the company didn't want to carry the real estate and related debt on its balance sheet. To accomplish the company's financial reporting objectives, the solution involved structuring a transaction that positioned the company to own 50% or less of the economics of the deal while maintaining a sizeable equity investment in the real estate.

This transaction required the company to comply with new and complicated accounting rules. The company's board of directors, plus its outside accountants, had to approve the structure of this transaction to ensure that the accounting requirements were met. The new accounting rules also mandated substantial disclosure requirements that revealed the specific nature and financial impact of this transaction.

Private equity funds will probably never be as transparent as REITs, yet as GAAP intensifies, both the scrutiny and compliance requirements of these rules will invariably increase the levels of transparency regardless of whether a company is public or private.

The Bottom Line

Investors today favor real estate private equity funds with strong internal accounting and operational controls, verifiable past performance statistics and documented policies and procedures. As a fund manager, having these systems in place will protect against bungling fund-raising efforts.

By recognizing both the extent and complexities of new reporting and compliance requirements, fund managers will give investors added confidence in the fund's financial structure. Such a move will also create improved, across-the-board operating efficiencies and a decisively competitive advantage for fund managers.

Scott Farb CPA, is the principal in charge of the national real estate group at Rothstein, Kass & Co. He is based in the firm's Los Angeles office and can be reached at [email protected].

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