New SEC Disclosure Requirements for the Private Funds Industry
BY: Henry Colocotronis
On August 23, 2023, the Securities and Exchange Commission (“SEC”) released final rules imposing new disclosure requirements on private fund advisers and restricting their ability to offer preferential terms to favored investors. Supporters argue that these regulations are long overdue given ordinary investors’ increased exposure to the industry, but critics believe that they will harm advisers and investors by imposing unnecessary costs and impeding their ability to strike mutually beneficial arrangements. However, both sides agree that these rules will have a major impact on the private funds industry.
The private funds industry, which includes hedge, venture capital, and private equity funds, has historically enjoyed light regulation. Funds were formerly only allowed to accept investments from “sophisticated” investors, but in exchange, regulators gave them wide latitude to structure their investment agreements. Two major developments created pressure to increase regulation. First, the major financial scandals of the late 1990’s and early 2000’s and the 2008 Crisis increased scrutiny of the financial industry. Second, the private funds industry has grown enormously over the past twenty-five years, driven primarily by increased flows from pension and endowment funds, who manage money for investors who would ordinarily not be able to invest in the space.
The 2023 Rules prohibit any adviser from offering any investor special withdrawal rights or access to information. Any rights to withdraw money from or receive access to information about the fund must be offered to all investors on the same terms. They also require advisers to disclose any other special material terms to all investors in the fund. In addition, the Rules limit the ability of advisers to charge investors for expenses related to regulatory investigations and enforcement, impose mandatory audit and disclosure requirements, and place additional regulations on the sale of stakes in a live fund.
Chair Gensler has explained that the Rules are meant to give investors more transparency into funds’ assets and activities and limit the ability of advisers to prefer favored investors. Investors will have greater ability to compare the performance of funds and more leverage to negotiate with advisers. Critics have two major objections to the Rules. One is a standard efficient contracting argument. These regulations will limit the ability of advisers and investors to craft bespoke agreements that suit their unique needs. When private parties can make individualized agreements, they are able to spread costs more efficiently. It may make sense to regulate the kind of agreements that parties are able to make where bargaining asymmetries exist, but the private funds industry is populated by sophisticated actors who can look out for their own interests. Additionally, they argue that the rules will disadvantage smaller funds, leading to less competition. New advisers frequently use preferential agreements to attract investors. The disclosure requirements impose fixed costs that large advisers will be able to spread across their funds, but smaller advisers will either have to internalize them or raise fees.
The actual impact of the Rules remains to be seen, but commentators have offered several predictions. First, there will likely be more standardization in the industry. The industry will likely adopt a relatively uniform set of terms and reporting formats. Because these Rules favor larger funds over smaller competitors, the industry may see more consolidation. Finally, investors will enjoy increased power, although the nature of the industry means that advisers will retain significant influence. Regardless, the once lightly regulated private funds space will be more regulated and mature.
Key Sources
Statement, Gary Gensler, Chair, SEC, Statement on Private Fund Advisers (Aug. 23, 2023), https://www.sec.gov/news/statement/gensler-statement-private-fund-advisers-082323
Statement, Hester M. Peirce, Commissioner, SEC, Uprooted: Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews (Aug. 23, 2023).
Alt. Inv. Mgmt. Ass’n., Comment Letter on Private Fund Advisers: Documentation of Registered Investment Adviser Compliance Reviews, at 21 (Apr. 25, 2022), https://www.sec.gov/comments/s7-03-22/s70322-20126739-287453.pdf
T.J. Bright Et. Al., The SEC’s New Private Fund Adviser Rules: A Guide to Compliance, K&L Gates 11 (2023)
https://files.klgates.com/webfiles/The_SECs_New_Private_Fund_Adviser_Rules_A_Guide_To_Compliance.pdf
Issa J. Hanna Et Al., SEC Adopts Sweeping New Private Fund Adviser Rules, Eversheds Sutherland (Oct. 2, 2023), https://www.corporatecomplianceinsights.com/sec-private-fund-adviser-rules/