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February 17, 2022

The SEC Private Fund Advisers Rule Proposal: How We Got Here

Fund Solutions

The U.S. Securities and Exchange Commission (SEC) proposed new rules and amendments for private fund advisers on Feb. 9, with industry reaction ranging from “it’s about time” to “OMG, what are they trying to do, kill us?” and lots of reactions in between. And, as if reading some industry minds, the SEC quickly followed this news by posting video on Twitter about why everyday folks should care about private funds and regulations. You should really watch this video if you think, “this too shall pass.” 

By Anne Anquillare, CFA, head of CSC U.S. Fund Services

We’ll release several blogs on the proposed SEC Private Funds Rules and the potential impact of those rules on you and your firms, as well as our thoughts on comments on the proposed rules. For our initial blog, let’s get some perspective on how we got here.

Compliance has been a growing focus for private fund investors and regulators for more than a decade. It all started with Dodd-Frank in 2010, which extended the requirements for registration under the Investment Advisers Act to advisers of private funds. That brought private funds under the jurisdiction of the SEC. The SEC didn’t publish requirements until 2011 and registration wasn’t required until March 30, 2012. The initial focus was on private equity firms with $150 million or more in assets under management (AUM). Smaller and venture firms also had to register, but were exempt from reporting requirements. Many large firms had already registered, so this change affected middle market firms most.

It took several years for the SEC to build up an examination group that could check on private funds. Since then, the SEC has issued numerous findings and published risk alerts. Ten years later, the SEC issued proposed rules that kick off the next phase of regulation for private funds. Many items in the new proposed rules are “to better enable our (SEC) staff to conduct examinations.” [1] there are many examples cited of the need for each proposed rule.

Initial thoughts

There’s good news and bad news about these proposed rules. Let’s start with the positive, glass half-full views on the proposed rules, assuming the SEC adopts them:

  1. These remove a lot of uncertainly on where the industry needs to be for alignment with regulators.
  2. Once implemented, the new rules will establish standards for all registered funds in reporting and disclosures, which will lead toward efficiencies and supporting technology.
  3. The new rules will streamline many of the negotiations around difficult topics like allocation of fees and expenses (e.g., management fee breaks will need to be the same for similar capital commitments and expense allocations must be pro rata, with no more free rides for related vehicles). Rather than having to negotiate these points one by one, general partners (GPs) can say the regulators are requiring this approach.
  4. Given the amount of disclosure required for any preferential treatment on terms, fees, or reporting, side letters might get a lot smaller, and fee and expense allocations might get simpler. All these disclosures need to happen prior to the first close, so any investors coming in on subsequent closes need to live with terms set before the first close. GPs will have to be confident they have market-based terms before they even have an initial close. This will be a difficult adjustment at first, but will avoid all the time and legal fees spent with negotiations and re-negotiations. It’ll be like buying a car today—all information is up front and is it difficult to get a “better deal,” especially from larger reputation-based dealerships? According to the SEC, “expediting the process for reviewing and negotiating fees and expense”[2] is one goal of the proposed rules. Time will tell.
  5. The difficult balance between fund level fiduciary duty and any preferential treatment of one investor will also limit many of the most complex practices. The SEC points out “…the interests of one or more private fund investors may not represent the interests of, or may otherwise conflict with the interests of, other investors in the private fund…”[3]
  6. The requirement to document, for the examiner to review, the annual review of a firm’s compliance policies and procedures will certainly create a trickle-down impact on compliance focus and spend. Set it and forget it, or revisionist history approaches will not work, which will hopefully limit all those exam findings and bad press for our industry. The SEC believes “…requiring written documentation would focus renewed attention on the importance of the annual compliance review process and would result in records of annual compliance reviews that would allow our staff to assess whether an adviser has complied…”[4]

Now for the potential downsides, especially for middle market funds:

  1. Reporting—a lot more data in less time—is going to have a disproportional impact on middle market firms. Many have already been moving toward the 45-day deadline, so hopefully it won’t be too difficult except for the dramatic increase in details. Even if this rule is modified down, start looking at your processes and systems.
  2. These rules span both registered and non-registered private funds, which expands the SEC’s turf for private funds and advisors of those funds, setting minimum expectations on compliance. What they ask of non-registered funds is not difficult; however, the expansion of turf should catch your eye.
  3. As many of the rules were designed to assist the examination staff, there could be many more damaging exam findings in the next few years as this rolls out.
  4. These rules might change how our industry does business in the long term. Many closed-end private capital firms have tremendous resources they can bring to bear for portfolio investments. Many investors and portfolio companies recognize these resources as competitive advantages when selecting an adviser. Much of the proposed rules center on disclosures about the compensation received for these resources. Rather than just disclosing fees and compensation received, a wiser approach might be to disclose not only the fees and compensation but how the related resource provides a service at or lower than market rates, and with equal or better quality. Our industry needs to provide these value-added services. Money, after all, is just a commodity—it’s the resources and the people in our industry that really generate the alpha returns. We need to perform the extra step of demonstrating the competitive or better nature of these resources for the compensation they receive.

Lastly, as mentioned, these downsides weigh heavily on the middle market of private funds. We hope the SEC considers increasing the minimum AUM for registration. And while the SEC released the proposed rules for comment at a hectic time of year for reporting and compliance resources at private capital firms, we really hope folks take the time to read and comment on the proposal. Comments are due by April 10, 2022. Please submit your comments to your industry organizations or, if you’d like, you can send them to us.

Next week’s blog will take a deep dive into a few of these topics as well as discuss how industry standards and your vendor ecosystem are important components for your path forward.

[1]SEC PRIVATE FUND ADVISERS; DOCUMENTATION OF REGISTERED INVESTMENT ADVISER COMPLIANCE REVIEWS; page 12

[2] SEC PRIVATE FUND ADVISERS; DOCUMENTATION OF REGISTERED INVESTMENT ADVISER COMPLIANCE REVIEWS; page 2

[3]SEC PRIVATE FUND ADVISERS; DOCUMENTATION OF REGISTERED INVESTMENT ADVISER COMPLIANCE REVIEWS; page 13

[4] SEC PRIVATE FUND ADVISERS; DOCUMENTATION OF REGISTERED INVESTMENT ADVISER COMPLIANCE REVIEWS; page 16