Equity Knowledge Series
A Synopsis of Responses to SEC Proposals on Private Fund Advisers
Fund managers and LPs register detailed responses to contentious SEC proposals on private fund advisors.
Jan 18, 2023
The CredCore Comment Matrix
Summary of SEC Proposals
Limited Partner Reactions
Since the passing of the Dodd-Frank Act in July 2010, the SEC has relied upon disclosure and a principles-based regime to regulate private fund advisers. Under the regime, advisers to large funds must adhere to a fiduciary standard of care and inform investors of any conflicts of interest. Limited partner agreements – and the fund management practices they endorse - can then embrace a range of terms as long as the adviser makes “full and fair disclosure to its clients of all material facts relating to the advisory relationship”1.
In recent years however, the SEC has signaled growing concern over perceived inadequacies with this system. A June 2020 risk alert classified deficiencies the SEC had uncovered during its examinations of private fund advisers into three areas: conflicts of interest, fees and expenses, and policies and procedures relating to material non-public information2. It found that these deficiencies “may have caused investors in private funds to pay more in fees and expenses than they should have or resulted in investors not being informed of relevant conflicts of interest concerning the private fund adviser and the fund”.
SEC leadership continued to raise these topics in a number of speeches in the ensuing months. Finally, to address the mounting issues it had identified, in February 2022, the SEC released a set of proposals under the auspices of the Investment Advisers Act that would, if enacted, upend the principles-based approach. In place of the emphasis on disclosure, the new proposals explicitly prohibit private fund advisers from engaging in certain activities while requiring them to implement others. In addition, the proposals specify in detail certain items that advisers must disclose to the Commission and to fund investors.
The SEC contends that the proposals will increase transparency and reduce conflicts of interest:
[A] lack of transparency regarding costs, performance, and preferential terms causes an information imbalance between advisers and private fund investors, which, in many cases, prevents private bilateral negotiations from effectively remedying shortcomings in the private funds market. We believe that this imbalance serves only the adviser’s interest and leaves many investors without the tools they need to effectively protect their interests, whether through negotiations or otherwise.3
Private markets have registered dramatic growth over the past two decades, with fundraising reaching a record high of nearly $1.2 trillion in 2021, up from $94 billion in 2003. As private markets come to occupy a larger role in the overall economy, the SEC sees more robust regulation as vital to protecting the interests of retail investors that participate in private markets through investments in institutional vehicles like pension plans.
Some of the proposed rules would also extend the SEC’s regulatory authority to cover a part of the industry that has traditionally enjoyed exemption from the Commission’s oversight. Dodd-Frank concentrates on large funds that are required to register with the SEC. A few of the new rules would expand the SEC’s ambit and apply to all private fund advisers, including previously exempt ones such as smaller fund advisers, venture capital fund advisers, and non-U.S. advisers.
The CredCore Comment Matrix
The proposals unsurprisingly generated a cascade of official comments, many lengthy and detailed, from participants and stakeholders in the private markets, including private fund sponsors, institutional investors, service providers such as law and accounting firms, elected officials, labor unions, and advocacy groups. At CredCore, we have placed these comments into a matrix that can be filtered by criteria such as the type of respondent, the general sentiment expressed towards the proposals, and the specific issues addressed by the respondent. The tool can generate results for queries such as “service providers with a negative view of the proposals that commented on audit-related provisions” or “general partners concerned with the cost implications of the proposals”. We hope this tool will be helpful to both policymakers and market participants as they shape their contributions to the ongoing dialogue.
To better understand the proposals as well as our comment matrix, we provide here a thumbnail summary of the key provisions of the SEC’s proposals. Following this summary, we describe some of the most commonly voiced reactions to the proposals from general and limited partners.
Summary of SEC Proposals
Annual Audit. Advisers would be required to obtain an independent annual audit on a GAAP basis for all funds it advises.
Adviser-Led Secondary Transactions. Advisers would be required to obtain a fairness opinion from an independent opinion provider in connection with adviser-led secondary transactions.
Borrowing. Advisers would be prohibited from borrowing any assets or seeking a line of credit from private fund clients.
Clawbacks. Advisers would be prohibited from applying tax-based clawback reductions.
Some background to the proposed rule: Advisers invariably earn performance-based compensation on top of base management fees. Advisers that draw performance-based compensation during a period when a fund performs well may be required - by virtue of provisions in a fund's governing agreements known as a clawback mechanism - to return it to investors if the fund subsequently experiences losses. Without a clawback to compensate investors, advisers would enjoy underserved, disproportionate gains.
However, it has also become common for governing agreements to contain further clauses that allow advisers to reduce the amount of any clawback payments by taxes the adviser has already paid or may be liable to pay on the performance-based distribution it received.
In prohibiting these types of reductions, the SEC asserts that the intended effect of the proposed clawback rule is “to ensure that investors receive their full share of profits generated by the fund” and contends that "reducing the amount of any adviser clawback by taxes applicable to the adviser puts the adviser’s interests ahead of the investors’ interests and creates a compensation scheme that is contrary to the public interest and the protection of investors, even where such practice is disclosed”.4
Documentation. Advisers would be required to maintain books and records related to the proposed requirements and document annual review of their compliance policies and procedures.
Expenses. Advisers can no longer pass on to investors certain expenses, charges, and fees, such as accelerated fees; fees for unperformed services; and any regulatory, audit, compliance, examination, and investigation costs.
Liability. Advisers can no longer secure terms that exculpate or indemnify themselves for "breach of fiduciary duty, willful misfeasance, bad faith, negligence, or recklessness in providing services to the private fund."
Preferential Treatment. The proposals explicitly prohibit two types of preferential treatment: a) granting preferential liquidity, and b) disclosing information on fund holdings to only some investors when doing so could have a material, negative effect on other investors who do not enjoy access to the same information. Meanwhile, all other forms of preferential treatment, such as that typically enshrined in side letters, need to be disclosed to all investors.
Pro-Rata Expenses. Private fund advisers would be required to allocate broken deal fees pro rata to co-investment vehicles to avoid disadvantaging LPs in the primary fund that do not benefit from the co-investment opportunities.
Quarterly Reporting. Private fund advisers would be required to issue quarterly reports that provide detailed, comprehensive data on both performance and fees/compensation. The reports would need to catalog all monies collected by the private fund adviser, including general fees, compensation paid by portfolio companies, and any amounts from offsets, rebates, and waivers. Requirements for performance reports differ slightly for liquid, open-end funds and illiquid, closed-end funds. The latter, which includes most private equity funds, would be required to state the fund’s net asset value; total contributions and distributions since inception; as well as gross and net IRR and MOIC figures for the full fund as well as both the realized and unrealized portions of the fund.
As might be expected, advisers have taken a dim view of most of these provisions. Among the more commonly voiced objections, advisers have:
Questioned the SEC’s statutory authority to regulate private funds as well as the necessity of the initiative. They cite progress made within industry groups towards remedying many of the issues identified by the SEC as well as the fact that the SEC is already able under current provisions to mete out penalties for practices the new proposals seek to address.
Challenged the likely efficacy of the proposals, arguing that they would often have the opposite of their intended effect. For example, by reducing the ability of investors to obtain custom reporting - as this might fall under the prohibition on preferential treatment - the proposals would curb, rather than promote investor disclosure.
Advocated for the continuation of a principles-based regime instead of the rules-based system the SEC seeks to introduce, contending that the former is more suitable to the diversity of fund types present in the private market ecosystem.
Registered concern over cost effects, worried that compliance expenses and new liability risks will prove onerous for many funds, especially small firms, and make their business models unviable. High expenses and liability risks might also create barriers to entry, inhibiting new fund formation and, by extension, the pool of capital available to fund new and growing enterprises.
Limited Partner Reactions
On the other side, limited partners have in their comment letters applauded most of the proposals, agreeing with the SEC on the necessity of introducing a more rigorous regulatory regime. They cite practices such as payments advisers make to related entities as emblematic of the conflicts of interest prevalent in the industry and note the difficulty they encounter while trying to reconcile non-standardized reporting practices. Despite their overall agreement, several investors have still sought to preserve their freedom to negotiate side letters and obtain any custom terms mandated by the government bodies that regulate their activity. Meanwhile, in response to concerns advanced by advisers regarding compliance expenses, some limited partners have argued to the contrary; that the proposals would actually reduce costs, especially those generated by legal negotiation and ongoing monitoring, in addition to facilitating more efficient capital allocation more generally. The proposals would thereby promote, rather than inhibit, economic activity.
Securities and Exchange Commission. Commission Interpretation Regarding Standard of Conduct for Investment Advisers. July 12, 2019. https://www.sec.gov/rules/interp/2019/ia-5248.pdf
Securities and Exchange Commission. Observations from Examinations of Investment Advisers Managing Private Funds. June 23, 2020. https://www.sec.gov/files/Private%20Fund%20Risk%20Alert_0.pdf
Securities and Exchange Commission. Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews. February 2022. Page 11. https://www.sec.gov/rules/proposed/2022/ia-5955.pdf
Ibid. Page 146.