The private capital overhaul arrives
The SEC argues sophisticated investors need protection, too
The SEC vs private funds
As private credit enjoys its “golden moment” and private equity’s biggest player hits $1tn in assets, regulators aren’t standing idly by. Last week, the US Securities and Exchange Commission passed sweeping new rules aiming to, as one commissioner put it, “recalibrate the baseline” for private fund disclosure.
The rules, passed under the Investment Advisers Act of 1940, fall into four buckets:
Standardised quarterly disclosure of performance, fees and expenses.
Limits on “side letters”. These are arrangements giving certain fund investors preferential terms. A pension investor with regular obligations might ask for shorter redemption windows, for example. Side deals that have a “material negative effect” on other investors are forbidden, unless the arrangement is available to all the fund’s investors.
A ban on fund managers passing through to investors legal expenses connected to Advisers Act violations.
Mandatory audits for private funds. Also, certain asset sales will require a third-party valuation opinion.
The final rules are more modest than the SEC’s initial proposal last year. Areas of particular heartburn for the private funds industry have been rowed back, including a lower liability standard for suing fund managers.
But there is still consternation. The biggest complaint is that the rules would raise compliance costs, hitting smaller funds the hardest. The limits on side letters (bucket 2 above) are harder to assess, and will depend on how the SEC enforces the law. Scott Beal, a partner at Barnes & Thornburg who represents both private funds and investors, says the change may disrupt the customised reporting templates many institutional investors currently use.
Brian Daly, a partner at Akin who also advises private funds on regulation, notes that the ban on passing through certain legal expenses (bucket 3 above) is more punitive than it might first look. He says that minor violations of the Advisers Act are routine parts of settlement deals, including no-admit-no-deny settlements, and are a cost of doing business for many fund managers. But the new SEC rules would result in funds having to internalise the costs of such settlements, even when settling is in the best interests of the fund.
Underlying all this is a familiar debate about sophistication. Put simply, do institutional investors need regulatory protection in the first place?
Investor advocates say smaller institutions need more disclosure to be on even footing with clever private fund managers. The industry replies that it already gives investors plenty of disclosure, in large part because funds must compete for investors, who employ legions of lawyers and MBAs to evaluate prospective investments. Tight-lipped fund managers with shady fee structures are hardly going to attract boatloads of capital, goes the argument.
“If an investment is too complicated or if an investor can’t really understand the fee structure, they should not be investing in that asset or that asset class,” adds Daly.
This disagreement (or, perhaps, clash of interests) on Wall Street is on display at the SEC. The libertarian-minded commissioner Hester Peirce wrote in her dissent that the private funds rules “will irreparably mar the regulatory landscape”:
Private funds have grown up, as Congress planned, outside of the requirements that govern registered investment companies, which are designed for the general public . . .
Private fund investors are . . . well represented by highly qualified professionals in their search for and negotiations with private fund advisers . . . . investors’ negotiation leverage is high — if they choose to use it. The regulatory regime reflects the sophistication of the parties . . .
Today, we are gearing up to impose a retail-like framework on this very institutional marketplace . . . . While the prescriptions being recommended for adoption today are less constricting than those originally proposed, they are nevertheless unnecessary government interferences in, and sometimes outright bans of, well-established practices. As long as investors understand the terms on which they are investing, why should the government care what those terms are?
Commissioner Caroline Crenshaw pushes back, calling arguments like Peirce’s “the sophisticated straw man”. SEC commissioners “have the unfortunate distinction of learning that investors of all stripes are the victims of fraud,” she writes, citing FTX (backed by, among many others, BlackRock and Third Point) and Theranos (backed by Fortress Investment Group and Walgreens). Even setting that point aside:
Informational and bargaining asymmetries flow to the advisers in this industry, to the detriment of investors . . . [For example, fund structure complexity makes it] difficult for investors to ever know (and therefore potentially remedy) the true extent of hidden conflicts of interest, or hidden fees and expenses. Moreover, despite the growing number of private funds, the space is in fact highly concentrated . . . Those largest advisers (including advisers to the aptly coined “mega funds”) have extreme informational and bargaining advantages . . . Even sophisticated investors accept suboptimal contractual terms for a number of reasons, including the fear that if they push for higher quality terms, they will lose access to current or future fund allocations.
The empirical question here is: just how competitive is the private funds market? Is it, as Crenshaw suggests, full of competition-busting information asymmetries, or is it, as Peirce writes, characterised by dynamism? (Readers with direct experience are invited to write in.)
Rory Callagy of Moody’s points to recent experience in the UK, where in 2017 the Financial Conduct Authority published a study of actively managed funds that demonstrated weak price competition. Since then, new fee disclosure rules (and the rise in passive investing) have improved value for investor money, the FCA found. “We’ve observed that when there’s more disclosure around fees that asset managers are charging, that typically leads over time to fee pressure on the industry, because investors are able to make a better assessment of whether they’re getting value for their money,” says Callagy.
UK active funds aren’t the same as US private funds. But the example shows that even in a well-lit market, barriers to competition remain. In more shadowy private markets, those barriers are surely higher. The SEC’s rules may have rough edges that need sanding off. But their core aim seems right.