SEC Takes on Private Equity, Hedge Funds
Commission to vote on final rules aimed at increasing transparency, driving down fees in opaque segment of finance
WASHINGTON—Wall Street’s main regulator is set to approve sweeping new rules aimed at overhauling the way private-equity and hedge funds deal with their investors, potentially the biggest regulatory challenge in years to firms such as Blackstone and Citadel.
The Securities and Exchange Commission plans to vote Wednesday on a rule package that would impose new requirements on so-called private funds, which manage some $25 trillion in gross assets for pension plans, university endowments and wealthy individuals. SEC Chair Gary Gensler and Democrats have a 3-2 majority, so the commission is expected to approve the final rules.
The rules would restrict a practice used by many private-equity and hedge funds to entice large investors by offering them special deals, known as side letters, for better terms than other investors. The SEC also would require private funds to provide their investors quarterly financial statements detailing their performance and expenses, and to undergo annual audits.
Some portions of the final rules have been eased from a proposal last year. Still, they would amount to a regulatory push into an area of finance long accustomed to minimal government oversight. Light-touch regulation and low interest rates have enabled private funds to grow larger over the past decade than the commercial banking sector, raking in hundreds of billions of dollars a year in fees, Gensler has said.
The Managed Funds Association, which represents hedge funds including Citadel, Bridgewater Associates and Millennium Management, and private-equity trade group the American Investment Council have tried to fend off the rules for more than a year. The groups say the SEC overhaul would force changes to the way they do business and, before the final rules were unveiled, signaled they might sue to overturn them.
Pension funds and other institutional investors typically allocate money to private funds in hopes of outperforming public stocks and mutual funds. The SEC has traditionally viewed such investors as sophisticated enough to fend for themselves in the market. So private funds have faced much less regulatory oversight than the mutual funds available to ordinary investors.
Investors in private funds must negotiate for any information they want to receive from the asset manager—including about the fund’s performance, holdings and costs—as well as for redemption rights and other terms. SEC staff say this creates opportunities for fund managers to charge opaque fees and expenses, give bigger investors a better deal than smaller ones, and exploit conflicts of interest.
One of the biggest sticking points for private-fund managers was the SEC’s proposed ban on certain side letters. These can, for example, give some investors greater flexibility to withdraw their money or offer them more information about a fund’s holdings. Industry officials say such agreements are useful for closing deals with marquee investors whose presence can bolster a fund’s credibility.
The final version of the SEC’s rules softens some language around side letters. The original proposal would have required asset managers to disclose a fund’s side letters to all investors before closing a deal; the final rule requires them to disclose only those side letters that involve “material economic terms.”
Giving certain investors special redemption rights or increased information about a fund’s holdings would be prohibited unless the asset manager offered those terms to all other investors in a fund.
SEC officials in the final version of the rules dropped plans to prohibit fund managers from charging fees for unperformed services and from limiting their own liability for malfeasance or negligence. Smaller funds also will get more time to comply with the changes than larger funds, and some of the new restrictions won’t apply to funds that were set up before the rules take effect.
Progressives in Washington have long been skeptical of private equity and hedge funds’ business models, but they have often struggled to turn their views into policy. Last year, Senate Democrats dropped a plan to raise taxes on carried interest, a key source of income for private-fund managers that many lawmakers see as a tax loophole.
Industry officials say they had a harder time dissuading Gensler, who is known for pushing aggressive regulatory changes. In the 18 months since the SEC proposed the rules, representatives of hedge funds, private-equity firms and venture-capital funds have met more than three dozen times with agency officials, SEC records show. They have also lobbied members of Congress to push back against the agency’s plans.