The Security and Exchange Commission’s new private fund rules are both good and bad, according to a broad spectrum of sources who have digested the agency’s final product.
The new rules have been described as the most sweeping new regulations for private funds since the passage of the Dodd-Frank Act – even after the SEC significantly mitigated much of its original proposals.
Sources from across the industry varied on their opinions on aspects of the new rules.
Much of the debate boils down to the balancing act of increasing transparency throughout private funds against the increased expenses that will result from new requirements and the potential ramifications.
“There will be short-term costs since it’s such a huge new rule and will require a significant compliance implementation effort. But it’s also an opportunity. More transparency will increase efficiency and competition and this brings cost pressures,” said Carlo di Florio, the global advisory leader at ACA Group who previously worked for the SEC and the Financial Industry Regulatory Authority.
The new rules prohibit fund managers from providing preferential terms previously available to certain LPs regarding redemption rights, access to portfolio information and various market exposure unless all investors are offered the same opportunity.
In addition, funds would have to provide advance notice of certain economic terms granted to already committed LPs to prospective investors.
Multiple people ranked the new preferred treatment regulations as the most important.
“More transparency better facilitates the alignment of interests while avoiding conflicts of interest,” said Daniel McCollum of Hirtle Callaghan, an outsourced CIO focused on endowments and family offices.
Increased transparency between LPs, along with disclosures made to potential investors, could allow LPs to better negotiate terms with fund managers – and could even prove disruptive to the typical 2 percent management fee system, according to one LP source who asked not to be named.
“Two percent of anything is expensive when you consider how much fees have gone down across every other asset class. There’s a large information asymmetry between LPs and GPs. Alleviating this is going to help us be better fiduciaries,” the source said.
But this could complicate the fundraising process, according to Karl Egbert, an attorney who co-chairs the global investment funds steering committee for Baker McKenzie. “It’s going to prompt more rounds of additional negotiations. It’s essentially going to require a pre-close before a pre-close before the actual close,” he said.
This could add to the length of time it takes for a new fund to close in an already difficult fundraising environment – many new funds hitting the market have limited partner agreements that have extended deadlines out to 18 months or more.
Allowing all investors access to portfolio information may also place limitations on certain activities between LPs and GPs, said Molly Diggins, general counsel for placement agent Monument Group.
“A lot of the information disclosed to certain investors and not others doesn’t necessarily have an impact on the fund. But it does lead to co-investments and other arrangements,” Diggins said.
New reporting measures
The SEC will now require funds to provide quarterly statements to investors – essentially what the agency requires from publicly traded companies. In addition, funds will now be required to obtain an annual audit distributed to its LPs.
“It’s going to allow for much more transparency on fees and expenses. And it’s going to help the SEC scrutinize the calculation and verification of a fund’s valuations and their expenses,” di Carlo said.
But quarterly reports may not mean much in an industry dependent on a years-long investment horizon. “I’m not sure what benefit quarterly reporting will have. Judging performance quarter-by-quarter is not relevant for a fund that’s investing in different portfolio companies,” Diggins said.
Managers must now obtain an independent fairness or valuation opinion for GP-led secondaries, along with disclosing a summary of material business relationships. GP-led secondaries and continuation funds have drawn the spotlight from regulators, especially as they have grown in popularity recently.
“A lot of LPs will welcome these changes. But mandating a fairness or valuation opinion might provide some benefits but it’s going to increase costs from the compliance,” Egbert said.
Managers will also need to devote much more money and time for the new compliance requirements, said Kelley Howes, an attorney with Morrison Foerster.
“These things cost money. It’s going to increase the number of staff members involved in compliance. It’s going to need more integration of custodial and administrative systems. A lot of smaller shops don’t have these systems, and that increases risks since you’re relying on humans using an Excel spreadsheet,” Howes said.
The new requirements will increase demand for accountants at a time when that industry is enduring a major talent deficit, according to Werner Barnard, the Chief Growth Officer at tax and advisory consultant SAPRO.
“GPs are going to have to seriously beef up on their valuations experts and managerial accountants in general. It’s going to require a lot more resource capacity, and that’s now something someone needs to consider against the backdrop of talent,” Barnard said.
Smaller firms hit the hardest
Emerging and mid-sized managers will feel the brunt of the new rules, several sources said. “KKR will be fine. It’s the smaller managers we have to worry about,” one source said. “This absolutely raises barriers of entry into the market,” Howes said.
Diggins said she is particularly worried about emerging managers who may struggle to pay increased expenses resulting from the new rules. “LPs are already hesitant to put their money in a tight market to a new fund,” she said.
And ultimately, the increased compliance costs will be paid for by LPs – the constituency the SEC looks to protect through its new rules, Howes said.
“It all comes back to the questions if this is worth it, because everyone’s expenses just went up,” she said.