Due Diligence Matters – September 2023 Bulletin

The SEC’s Private Fund Advisers Rules – August 2023

“More regulation is not the best answer to every problem” Jerome Powell

Under Joe Biden’s administration, Gary Gensler’s interventionist agenda is being seen as either a long overdue tightening of regulatory rules to protect an ever-growing group of investors in private markets, or as a deliberate move on the US financial community masquerading as investor protection. Either way, practically speaking, what do the new rules mean for investment advisers (“IAs”) and investors now, and do they offer benefits to IAs, investors and the private markets industry going forward?

Despite the noise, no immediate changes

The earliest date at which the rules would come into effect is 25 September 2024 (for IAs with an AUM >$1.5bn) or 25 March 2025 (for IAs with an AUM <$1.5bn). Twelve months is not a generous amount of time, so IAs will need to start preparing soon, notwithstanding the fact that six groups, including AIMA and the MFA, are suing the SEC, arguing that it has exceeded its authority. ODD teams will undoubtedly start to ask how IAs are preparing for the changes and start comparing the approaches of IAs and their compliance/legal teams regarding their application.

What is the scope and who could it affect?

For new investments/funds:

  • Recordkeeping – US RIAs
  • Compliance review – US RIAs and Non-US RIAs
  • Adviser-led secondaries – US RIAs and Non-US RIAs (for US funds only)
  • Quarterly statements – US RIAs and Non-US RIAs (for US funds only)
  • Private fund audits – US RIAs and Non-US RIAs (for US funds only)
  • Certain restricted activities – US RIAs, Non-US RIAs (for US funds only) and ERAs (for US funds only)
  • Preferential treatment – US RIAs, Non-US RIAs (for US funds only), ERAs (for US funds only)
  • For existing investments/funds, restricted activities (requiring consent) and preferential treatment do not apply. However, quarterly statements, audit, adviser-led secondaries, restricted activities (disclosure-based) and disclosure of preferential treatment do apply.

Who are the winners and who are the losers?

Investment Advisers – Losers
It is hard to see how IAs will benefit from these changes. Arguably, they reduce the scope for attracting investors with bespoke solutions/terms and increase the complexity of the capital closing process through added disclosures to investors, as well as the compliance burden and cost.

The effect of prohibiting preferential treatment with regard to liquidity and material information without disclosure, and, in some cases, the requirement for investor consent, may mean that all investors will be offered the terms and fees that the large allocators typically negotiate, leading to lower profits for IAs. Rewarding investors with better fees for accepting worse liquidity appears to be possible under the rules, as long as these options are available to all investors, not just those, for example, who can make a larger initial investment, or those who are employed by the IA.

IAs may need to enhance their governance arrangements to ensure quarterly performance reporting is not misleading or inaccurate. ODD teams will focus on these policies and procedures more closely.

IAs may need to revise LPAs and other fund governing documents, and without further clarity from the SEC, varying interpretation of certain terminology like ‘material economic terms’ and ‘similar pool of assets’, could lead to uncertainty.

Investigation-related fees, regulatory/compliance fees, clawback reductions, non-pro rata fee and expense allocations, and fund borrowings will require disclosure to investors or investor consent.

Investors – Winners and Losers
How can investors be losers from tightened regulatory rules? Having canvassed a few of our industry colleagues, there are mixed responses. For example, one group is concerned that, since it is typically an ‘early-bird’ investor, it may lose fee benefits if the IA is forced to offer the same terms across the board, regardless of the added risk the group is taking by allocating early. So there could be less incentive to do so, making it harder for funds to achieve capital-raising targets. Furthermore, we do not get any sense that the additional disclosures, which are intended to improve investors’ ability to monitor performance thereby promoting investor risk-taking, will result in more capital being deployed. Another unintended consequence will be the IAs passing through additional reporting costs to the funds, at the expense of investors.

The winners are those who believe that the new rules address deep-seated intransient problems in the private markets industry. Smaller investors without the capital clout of some of the largest pension funds, endowments and asset managers, may find themselves on a more level playing field and in a better position to assess investment opportunities. We may see the end of priority or favourable ‘tiering’ of terms and information to favour some investors over others. According to one Head of ODD of an asset manager, ‘additional information/transparency is helpful, but we don’t necessarily get the best material terms, so that enforcement is a win-win’.


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Missed the last bulletin? Click here for the August 2023 edition.