In early 2022, the U.S. Securities and Exchange Commission (SEC) voted to propose amendments to Form PF and the Investment Advisers Act of 1940 (Advisers Act). These votes came after the SEC’s almost decade-long scrutiny of the private equity market. After signaling its intent to regulate the previously unregulated private markets, the SEC took a step toward overhauling them. Let’s look at the context around the proposals, the potential amendments, and how private fund managers can prepare for the future.
Context surrounding the SEC’s focus on private markets
U.S. private funds have grown significantly in recent years rising from over $9 trillion gross assets under management (AUM) in 2014 to $18 trillion gross AUM by 2021. Additionally, in each year for the past decade, the private markets have raised more capital than public markets. Reasons for the explosive growth are multifold and complex and include relaxed restrictions around private markets by both Congress and the SEC.
Are private equity firms regulated?
Because the private markets have been largely unregulated, private investment firms and investors have been free to contract and build their own set of market customs and agreements. One example is the proliferation of side letters. A decade ago, side letters were rare. These days, it’s common for every investor in a fund to have their own.
While side letters are one example, there are a host of agreements and customs the private markets keep confidential from the public, government, and even other investors in the same fund. The result is the public has little insight into how private companies and funds operate. In other words, the SEC is “watching a growing portion of the US economy go dark,” and it’s concerned.
Central to the SEC’s concern is that private market activity could negatively affect a growing and increasingly less knowledgeable set of investors. Many private market investors are highly sophisticated institutions like sovereign wealth funds, insurance giants, and large endowments. However, there’s been a shift from these institutional investors to high-net-worth individuals. The SEC believes these individuals may not understand the full scope of their private markets investments or have the institutional power to negotiate terms on equal footing with the larger investors.
The trend toward regulation for private equity is based on the SEC’s belief that it’s in the public’s best interest to mitigate the risk of bad actors and preferential treatment, which could harm individual investors.
SEC solidifies intent with proposed amendments
Form PF, adopted in 2011, is the confidential reporting form the SEC requires many SEC-registered private fund investment advisers to complete on a quarterly basis. After a decade of data and analysis, the Financial Stability Oversight Council believes information gaps on Form PF prevent it from adequately assessing systemic risk.
If approved, the proposed Form PF amendments would:
- Create new reporting requirements for certain events for large hedge fund and private equity advisers
- Lower the reporting threshold for large private equity advisers
- Update reporting requirements for large private equity advisers
The Investment Advisers Act
Additionally, the SEC proposed changes to the Advisers Act, which regulates the activity of private investment advisers. The proposed change would significantly increase regulation of the private equity sector.
The proposed amendments would require advisers to:
- Provide quarterly statements to investors detailing the fund’s performance, fees, expenses, and other factors depending on the fund’s liquidity
- Obtain an audit for each private fund annually and at liquidation, and require the auditor to notify the SEC of a modified opinion or the auditor’s dismissal or resignation
- Provide investors with a fairness opinion and written summary of certain material business relationships between the adviser and the opinion provider for adviser-led secondary transactions
- Document, in writing, an annual review of their compliance policies and procedures
The Advisers Act amendments would prohibit all fund advisers from engaging in certain activities that go against the public interest, including:
- Charging certain fees and expenses to a private fund or its portfolio investments
- Charging fees or expenses related to a portfolio investment on a non-pro rata basis
- Seeking reimbursement, indemnification, exculpation, or limitation of certain liabilities
- Borrowing or receiving an extension of credit from a private fund client
- Reducing the amount of an adviser clawback by the amount of certain taxes
These potential changes have garnered pushback, including a statement from Simpson Thatcher calling the SEC proposals “intrusive.”
The SEC also focused on the preferential treatment of investors. The amendments would prohibit fund advisers from providing certain types of preferential treatment that have a material negative effect on other investors and any other preferential treatment unless the adviser discloses it to current and prospective investors. Often such preferential treatment is confidentially negotiated in side letters between private fund managers and their investors.
Opponents of these amendments take particular issue with these prohibitions, claiming it isn’t necessary for the SEC to regulate commercially negotiated terms, many of which have become standard practices within private equity.
The potential impact of SEC regulatory changes
Although we don’t know if the SEC will adopt the proposed rules, the trend toward private equity firm regulation is clear. Private equity firms can best mitigate regulatory and reputational risk by considering the consequences of the proposed amendments.
1. Increased scrutiny of adviser and investor relationships
To begin with, private equity firms might experience closer examination regarding their limited partnership agreements (LPAs) and side letters. For example, it has become more common for investors to have modified or eliminated fiduciary duties in their private equity funds. This is true despite Chair Gensler affirming fiduciary duty waivers are inconsistent with the Advisers Act at the 2021 Institutional Limited Partners Association Summit. New regulations may prohibit such waivers and, overall, decrease firms’ and investors’ latitude in how they navigate their side letters.
2. Numerous disclosure requirements
Several of the proposed amendments would create routine reporting to the SEC and investors, as well as disclosures based on particular events. The Form PF amendments would require private equity firms to file reports within one business day of reporting events. Additionally, lowering the reporting threshold from $2 billion to $1.5 billion in private equity fund AUM catches additional advisers. Simply put, more firms will have to give other parties more information.
3. Additional accounting and legal tasks
New reporting obligations mean more work for private equity firms, particularly for their accounting and legal teams. Firms will have to devise new internal processes and workflows and update their compliance programs. Managing the change as well as the ongoing requirements will require a significant upfront investment in time and energy.
Prepare for a new regulatory future
It’s unlikely the SEC will pull its focus away from private equity anytime soon. The trend is toward more regulation, whether the current proposals pass or not. That conclusion is evidenced not only by the SEC votes, but also by enforcement actions in recent years and public comments.
For the fiscal year 2021, the SEC brought 434 new enforcement actions, 159 of which were against registered investment advisers (23%). The Office of Compliance Inspections and Examinations (OCIE) published a risk alert in June 2020, offering its observations on common deficiencies. OCIE commonly found issues involving conflicts of interest, fees and expenses, fiduciary duty waivers, and material nonpublic information. Chair Gensler also spoke publicly about his concerns regarding those issues, as well as the lack of transparency regarding fund performance metrics and preferred terms in side letters.
Minimize the cost of compliance with Ontra
All in all, the SEC hasn’t hidden its agenda. The SEC intends to increase regulation within the private markets, and the best response is for firms to prepare by improving their fund obligation tracking systems and compliance programs. Fortunately, there are technology tools available to help private fund managers address the SEC’s recent statements and put themselves ahead of the regulatory curve.
Years ago, Ontra noticed the difficulties asset managers faced in tracking the growing numbers of obligations across their increasingly complex body of side letters. That’s why we created Insight. Insight transforms complex private equity fund agreements into structured data and delivers a unique set of workflow and reporting tools. Our solution enables firms to easily oversee their obligations and restrictions, reference what they’ve agreed to in their LPAs and side letters, and benchmark against all the historical documents they’ve signed.
Insight is a powerful tool for addressing enhanced reporting requirements, a comprehensive solution for managing legal obligations in LPAs and side letters, and the best tool for ensuring trust among investors and regulators.