April 25, 2022
With private funds limited to qualified purchasers and accredited investors under Regulation D, and furthermore section 3(C)(1) or 3(c)(7) of the Investment Company Act of 1940, most all private fund investors are sophisticated investors and not generally the retail public. Sophisticated investors who are high net-worth individuals and institutional investors are permitted to invest in private placements that the general public is typically not allowed to invest in. The SEC has been charged with watching over and protecting small, unsophisticated investors.
This SEC proposal of new rules and amendments for private fund advisers veers away from the SECs historical regulatory premise of full and fair disclosure of informed consent and negotiations among sophisticated parties and is moving towards a more prescriptive regulatory framework that would typically be structured and targeted towards retail investors. This is treating sophisticated investors as if they are retail investors. There is a big difference between sophisticated investors and retail investors, where sophisticated investors need additional flexibility for separate negotiations to meet their investment needs and objectives. Sophisticated investors are capable of performing their own due diligence and able to make decisions without small investor protections.
The proposal covers the following areas:
Quarterly Statements:
Requiring quarterly statements and reports may put an undue burden on some advisors with limited resources. Some Illiquid funds will likely face difficulty obtaining the necessary reporting information for their portfolio investments and estimating the unrealized portions of their portfolio. This will likely drive up the cost for assets properties. Also, older funds may have difficulty providing the required information for all periods, and the costs could increase end-of-term costs when funds are winding-down.
The new proposed rules related to Fee and Expense Disclosure and Performance Disclosure are very specific technical rules which will be low-hanging fruit for examinations and enforcement actions. Given the specific requirements with respect to content and formatting, the SEC giving out many technical violations on these reporting requirements. Theres also the question if special purpose vehicles (SPVs) would also be required to get audited financial statements that hold investments below the fund level, which would really add additional expense.
Mandatory Private Fund Adviser Audits
A significant number of RIA already obtain annual financial audits of their private funds from an independent public accountant using GAAP as required by the custody rule. In some cases, investors and the RIA may determine that annual audited financials arent necessary due to the cost and size of the offering and the cost and they should have this option of not making it mandatory. Also, theres a limited supply of accounting / audit firms where it may not be practically feasible based off of the sheer volume of auditing work.
Imposing mandatory audits and GAAP usage are unlikely to provide the desired benefits while imposing costs on all funds. Some funds may be unable to bear these costs, potentially discouraging capital formation and, ultimately, economic activity and innovation.
Adviser-Led Secondaries
Requiring fairness opinions in adviser led secondary transactions and summary of any material business relationships between the RIA and the opinion provider is too much. This is an added expense and time delay for secondary transactions that shouldnt be required. Any conflicts of interest with opinion providers would be required to be disclosed in the Form ADV.
Prohibited Activities
The proposed rules for 1) Fees for Unperformed Services 2) Certain Fees and Expenses 3) Adviser Clawbacks for Taxes 4) Limiting or Eliminating Liability for Adviser Misconduct 5) Certain Non-Pro Rata Fee and Expense Allocations and 6) Borrowing are significant departure from the current private fund structure and will likely create new challenges for private fund advisers. It would not allow for fund sponsors and investors to negotiate terms even if fully disclosed in offering documents. There already are rules, like Rule 206(4)-8 that prohibits an adviser from committing fraud against investors.
Without tort reform, investors could blame asset manager for investment losses. Managers will no longer be able to be exculpated and indemnified, or that ability will be reduced, shifting an intolerable burden to fund managers that will have disastrous destructive affects to the entire economy by stifling capital creation in the extreme.
This will likely expose advisers to increased litigation and result in higher insurance premiumswhich could ultimately lead to increases in management fees or expenses borne by private funds and their investors.
Preferential Treatment
This new requirement to provide specific disclosure to all investors regarding any preferential redemption terms prior to their investment will increase the burden on advisers, particularly those sponsors with numerous side letters, and could cause significant delays to close.
As pertaining to side letters, it will make it harder for new private equity firms to arise. It's difficult for new companies to get started and side letter agreements often help a private equity firm attract some initial investors. This rule makes it harder for new firms to offer flexibility, as early investors may get a promising deal to sign up and if other investors know about those deals, they will want the same which may ultimately ruin business viability and limit flexibility.
The proposal isnt clear regarding the prohibition of multi-class fund structures with different liquidity terms, which is a common industry practice.
Proposed Written Documentation of All Advisers Annual Reviews of Compliance Programs
Requiring a written report of compliance review is unnecessary as the SEC can at any time review the RIAs current and past compliance programs and determine if sufficient to meet all of the SEC regulatory requirements. Requiring written reviews takes a significant amount of time and resources and shouldnt be necessary to prove to the SEC that an annual review and update occurred. The advisers compliance program review should be confidential and not required to be given to the SEC. If a firm is proactive and hires an attorney or compliance firm to perform a mock audit or reviews to strengthen its compliance program, the adviser shouldnt be required to hand over to the SEC the audit reports identifying deficiencies. This actually deters some RIA firms from having compliance consultants and outside counsel prepare compliance reviews.
With the increasingly more complex regulatory environment, this proposal will contribute to this trend, which could ultimately result in increased fee pressures. The proposed rule changes will increase adviser compliance / operational costs and harm the ability to raise capital. Higher costs for fund managers will be passed through to their limited partners. With the proposed rules increase of cost and complexities of this proposed rule, competition will be reduced, not increased as stated in the proposal. Adding cost to advisers platforms will decrease efficiency, not increase as stated in the proposal. Smaller investment advisors will be driven out, leaving the larger and more well-funded sponsors at the table. Additional costs will have a negative impact on smaller firms, driving many of them to extinction and furthering market consolidation. Startup advisers will have a much higher barrier to entry, reducing completion and innovation. There is a strong case that advisers will need to raise management fees which will negatively impact investor returns.
Competition will be reduced if the same rules apply equally to all small, mid, and large-size firms. Many smaller, early-stage funds struggle to raise capital. This proposal will inhibit smaller advisers that include minorities and under-represented classes, reducing diversity. If these rules go into effect, many successful smaller advisers who have been successful in the past likely wouldnt be as successful now in this new proposed environment. These rule changes will also have an impact of likely fewer prospective investors who will participate in new private placement offerings due to the increase in fund fees, increased regulatory involvement, investment risk and reduced liquidity.
I am against this proposal and urge it be rejected. If any of this rule is adopted, it should only apply to large advisors of a certain size, i.e., over $2.5 Billion of assets under management. In addition, allowing only one year to come into compliance with these rules isnt nearly enough time as many RIA will need to find new reporting vendors to help with all of these required rule changes.