More & Fair Return to Investors: The SEC New Private Fund Rule

The U.S. SEC adopted new rules under the Investment Advisors Act of 1940. The reforms are designed to protect direct and indirect investors (e.g., retail investors through pension funds) in #privatemarket funds by increasing visibility to certain industry practices and enhance fairness and equitable returns to all the investors. Below are the key aspects of the new private fund rule that was adopted on August 23, 2023.

Applicable ONLY to the registered private fund advisors

Quarterly reporting and annual audit: Advisors must provide quarterly performance reporting including details of all the fees and expenses. They are also required to obtain an annual audit of the private fund.

Fund performance with and without subscription lines must be reported under the new rule.

I can confirm from my own experience as an LP investor in the past that comparing performance of funds from different advisors quickly becomes complicated and messy in the presence of subscription lines as different funds from different advisors employ subscription lines very differently. Hence, mandating performance reporting with and without subscription lines under the new rule would help investors separate true performance from leveraged performance resulting from credit line utilization.

GP-led secondaries: With a decline in exits from reduced deal activity and IPOs, continuation funds are on the rise. The #SEC has mandated that all GP-led #secondaries which continuation funds are of a type, must receive a third-party fairness or evaluation opinion and the relationship with the opinion provider must be disclosed.

Applicable to all private fund advisors

Preferential treatment/ side letters: Another big area of impact is side letters. Side letters is the private market investment industry’s way of customizing terms and conditions with each investor client outside of the standard legal documentation such as PPM, LPA etc. Instead of completely prohibiting any type of preferential treatment to private fund investors the reforms prohibit some preferential treatment while for others the rule requires that existing and prospective investors receive written notice of the preferential treatment, i.e., disclose all the side letter terms to all the investors. The prohibited items are preferential redemption rights and portfolio holdings disclosures unless those are offered to all the investors.

The SEC is attempting to level the playing field for large and small investors in private market funds by targeting side letters.

Restricted activities: Under the new rule, the advisors are restricted from charging certain fees and expenses to the investors such as an advisor’s compliance fees and regulatory investigation fees as well as expenses related to either of the two unless they provide certain disclosures to investors. From my experience, some private funds already address these items in their fund documents while others apply them in favor of either the fund or the advisor without explicitly stating it in the fund documents.

Similarly, items such as reduction of clawbacks by actual or accrued taxes due on principals, allocation of deal expenses on a non-pro rata basis (e.g., not allocating broken deal expenses to co-investors) and borrowing from fund investors require disclosures to all the investors.

Further, allocation of an advisor’s regulatory investigation fees as well as related expenses and borrowing from fund investors also requires consent from investors.

Carveouts from the final rule

As a sigh of relief for the GPs, there are some exceptions provided in the final ruling as compared to the proposed ruling:

• A big carve out is that the securitized asset funds are generally not included in the new private funds rule.
• Prohibition from charging fees for unperformed services (e.g., monitoring fee) was left out.
• Disallowing certain waivers or indemnifications also did not make it to the final rule.

The reason SEC provided in its final release for not adopting the last two was that those protections were already available to investors as fiduciary obligations of advisors under the Advisors Act of 1940. So, it may not be a real relaxation given the SEC’s interpretation of the law. It might be prudent to keep an eye on these items as the regulatory landscape further evolves.

To conclude, the rule while creating additional compliance burden on GPs are beneficial for the sustained growth of the industry. It creates a level playing field for investors to be treated fairly while promoting transparency in the GP practices. Prohibition of allocation of certain fees and expenses to investors effectively compresses the management fees and improves return for the investors, a trend already in making. I believe these changes will make the private market investment industry more competitive and attractive for investors by instilling greater confidence in the industry practices.

However, not everyone equally believes that these reforms benefit the private alternative investment industry and a coalition made up of six industry groups filed a lawsuit against the SEC challenging the new private fund adviser rule. The six organizations are: Managed Funds Association, American Investment Council, National Venture Capital Association, National Association of Private Fund Managers, Alternative Investment Management Association, and Loan Syndications & Trading Association.

What do you think? Do you believe that these reforms were much needed to create a level playing field or these will only create additional costs for GPs and increase friction between different industry stakeholders?

Sources

The SEC final ruling documents: https://www.sec.gov/rules/2022/05/private-fund-advisers-documentation-registered-investment-adviser-compliance-reviews

Interpretations from various industry experts:

• Opalesque Webinar with Chris Addy from Castle Hall
• troutman.com/insights/new-sec-private-funds-rules-what-is-happening-and-what-you-need-to-know.html
• dentons.com/en/insights/alerts/2023/august/28/sec-adopts-final-rules-for-private-fund-advisers

#institutionalinvesting #privatefunds #duediligence #privateequity #privatedebt #alternativeinvestments #privateassets #privatecapital #institionalinvestors #lps #privatemarketinvesting