Sweeping U.S. Private Funds Regulation Changes To Impact Both Managers and Allocators
On August 23rd, US regulator the Securities and Exchange Commission voted to adopt new rules to ‘enhance the regulation of private fund advisers and update the existing compliance rule that applies to all investment advisers’.
The new rules are complex and have wide-ranging implications. Numerous industry groups have joined together to sue the SEC ‘on the grounds that they exceed the agency’s statutory authority and are arbitrary, capricious, and otherwise unlawful.’
The stage is set for something of a battle royal, with an SEC spokesperson writing in an emailed statement to AlphaWeek that, “the Commission undertakes rulemaking consistent with its authorities and laws governing the administrative process, and we will vigorously defend the challenged rule in court.”
If the SEC wins, then the new and updated rules remain. And the first implication falls right on the doorstep of the smaller and emerging manager.
“The cost factor of complying with the new rules will be significant, particularly for smaller managers with smaller AUM” said Tim Clark, Partner, Global Head of Private Funds & Secondaries at law firm Freshfields Bruckhaus Deringer in New York. “The larger managers with more products can spread the incremental compliance costs across the AUM of those products, and many of them have established reporting protocols already in place that comply with at least some of the new reporting rules. As such, the reporting elements of the new rules should have less of an impact on larger AUM managers.”
Still, whilst the larger manager may be less affected, the new rules still provide the SEC with more touch points where the regulator could find managers deficient in terms of their compliance with the rules, meaning managers of all sizes will be spending more time, as well as money, to prepare for an SEC audit. And the preferential treatment rule also applies to exempt reporting advisors – managers running less than $150mn across all products.
The preferential treatment rule is one of particular consternation. Rule 211(h)(2)-3 essentially prohibits private fund managers from offering or implementing preferential terms for investors unless it’s disclosed to other investors. That’s not ideal for many managers on a good day, but again, this rule looks likely to impact the newer and emerging manager, particularly in the hedge fund space.
“In the hedge fund world, and to a limited extent in the PE fund environment, there are investors who seed new managers – it’s a one stop source of capital to put new managers in business. The price for this seed capital, among other things, often includes the option for the seeder to invest in future fund products raised by the new manager, usually on preferential terms. The question is, given the new rules focus on transparency of preferential investor treatment, whether that visibility will make it less attractive to a newer or emerging manager to take seed capital. In the past, fund investors would be made aware that there was a seeding arrangement, but the details of the seed arrangement may not have been disclosed to investor in the granular way required by the new rules. It’ll be interesting to see how that will play out,” said Clark.
The preferential rule also applies to exempt reporting advisers – managers running less than $150mn across all products.
The SEC claims that the new and updated rules are designed to ‘protect private fund investors by increasing transparency, competition, and efficiency in the private funds market.’ This increased transparency would likely be welcomed by many investors, but as with any regulatory change, there is usually a side effect, and in this case, it’s an increased administrative headache.
“All this information sounds like a great thing, but some investors will now end up receiving more information than they can reasonably process. There are outsourced advisors to help, of course, but investors and their advisors will now have more information to sort through, which means added time and more cost to the investor. And LPs who previously didn’t outsource now might have to consider doing so because of the additional bandwidth required,” said Clark.
The private funds industry will be hoping that the industry groups that have filed suit against the SEC will win. But if they don’t, Clark says that whilst the impact will be significant, he doesn’t believe new fund launches will be impacted as much as it might seem.
“You are definitively adding more cost into the system earlier on and it will be more challenging for managers to pick up that cost. However, although the new rules may impact certain new manager formation, it is probably premature to predict now that it will have a material anti-competitive effect on new market entrants.”
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