The U.S. Securities and Exchange Commission was clear that its new Private Fund Adviser rulemaking is geared toward leveling the playing field for investors and managers alike, but lawyers in the industry are not convinced.
Investor protection is not a given, lawyers say, as they flush out the complex set of rules that will dramatically shift the business practice of managers and investors alike.
Two key sections of the new rule signal a massive change in how private fund managers negotiate fees and terms with end investors. This includes the prohibition of certain activities and practices that are contrary to the public interest and the protection of investors unless they provide certain disclosures, and in some cases, receive investor consent. Additionally, the new rule prohibits preferential treatment that has a material negative effect on other investors and other types of preferential treatment unless disclosed to current and prospective investors.
“The preferential treatment rules are likely the most problematic,” commented Genna Garver, partner at Troutman Pepper. “While the final version includes much needed modifications to address concerns from both LPs and GPs, it’s unclear how the dust will settle.”
Garver added, “Certain smaller or less established GPs may have been willing to negotiate terms to get money in the door and may see this as losing a bargaining chip to attract larger investors — we do this in all walks of life, not just private funds.” She used the example of a new landscaping company who may want to offer new customers a promotional rate.
For LPs, she said, they may be thinking along the lines of what Commissioner Hester Peirce said during last week’s meeting. In her dissent on the rule, Peirce pointed out “conditioning preferential rights on offering them to everyone sounds like a ban on offering preferential rights, but the release does not characterize what we are doing as a ban.”
Garver also sees compliance becoming a challenge, especially with preferential transparency because right now it’s not evident how an advisor can make a determination as to whether providing information would have a material, negative effect on other investors.
“The adopting releases states that the ability to redeem is an important part of determining whether providing information would have a material, negative effect on other investors and thus whether an adviser triggers the preferential information prohibition,” Garver said.
Mike Mavrides and Rob Leonard, partners at Dechert, noted that following the SEC ruling, managers will have some legacy status as to certain aspects of the rules relating to restricted activities and preferential treatment/side letters for arrangements in place prior to the compliance date for the rule. The rules will be effective 60 days after publication in the Federal Register. Then the compliance date for the quarterly statement and private fund audit rules will be 18 months after the effective date.
New fee regime?
Managers though are facing greater uncertainty regarding their interactions with investors and prospects as a result of the prohibition against preferential information, the Dechert partners added. At the same time, they said managers are facing higher costs in operating their business which may get passed on to investors.
Some of the cost may be due to extra disclosures when it comes to performance reporting and ensuring what is offered to one investor is offered to all. And other parts of the equation of the sheer cost of compliance auditing on an annualized basis.
“Registered advisers to private funds will need to provide certain standard reporting, the expense of which will likely be paid indirectly by investors,” said Daniel Bresler, partner in the Investment Management Group at Seward & Kissel in New York. “Many investors already receive the information they consider relevant so may gain limited additional benefit from the reporting.” Bresler said the requirement for a fairness opinion or valuation opinion for adviser-led secondary transactions especially will increase costs borne by investors.
But the key issue remains that large investors, advisers being required to disclose any preferential treatment to other investors may limit an adviser’s willingness to agree to certain side letter terms, Bresler said. Experts say this could hamper future fundraising.
Potential for litigation?
Lawyers working with private funds will be laser focused on SEC guidance to gain clarity on the workload ahead.
“We will continue to monitor this closely and will see what guidance, if any, the SEC issues in the coming months on the important issues not addressed,” said Dechert’s Mavrides and Leonard in a statement.
Some in the industry have been adamant that litigation will come out of last week’s rulemaking as it is viewed as an overreach of the SEC in meddling in business negotiations. Representing GPs from both the hedge fund and private credit side the Managed Funds Association (MFA) expressed it’s concerns for its membership. MFA President and CEO Bryan Corbett stated, “MFA will assess the final rule and work with our members to determine the appropriate next steps to protect the interests of alternative asset managers and their investors, including potential litigation.”
Troutman Pepper’s Garver said that the proposed waiver or indemnification prohibition that would seek reimbursement or limitation of liability by the private fund or its investors for a breach of fiduciary duty was removed, which could spark problems. “The SEC seems to have done some gymnastics to thread the needle for issuing private funds rules under Section 211,” Garver added. “It’s possible we may see a challenge to that authority.”
