The US SEC has voted, with two commissioners dissenting, to usher in new rules and overhaul the $18trn private fund marketplace in ways that will have an impact on this fast-growing sector – but not as profoundly as many had feared.

Registered investment advisory firms that manage private funds or recommend them were watching closely to see whether a reform package requiring detailed disclosures, auditing, and an end to certain industry practices would get the full the go-ahead. The Commodity Futures Trading Commission (CFTC) joined the SEC on the proposed amendments insofar as it pertains to those funds that also are registered with the CFTC as a commodity pool operator.)

The agency proposed the six-part rule in February 2022, and Chair Gary Gensler was a big advocate for these proposed changes, plus a slew of other rule proposals lingering at his agency, all aimed at greater investor protection.

He has drawn pushback from the industry about regulatory overreach, and his watered-down version of the private fund rule amendments only satisfy some of their concerns.

Disclosure and Form PF

Because of the growth of private funds, among other concerns, the SEC and CFTC’s new rules mainly revolve around a disclosure form called “Form PF”. The rules add more transparency by mandating greater reporting.

Certain disclosure rules apply to all Form PF filers and, in another section, applies to large hedge fund advisers who advise qualifying hedge funds (defined as hedge funds that have a net asset value of at least $500m).

There was no change made to private fund liability rules; the agency’s original plan would have allowed investors to sue for “negligence” rather than “gross negligence”.

The new requirements for private funds such as hedge funds and private equity groups, involve disclosing quarterly performance and fees charged to investors, and to disclose certain fee structures, while also barring giving some investors preferential treatment over redemptions and portfolio exposure.

The rules also require funds to perform annual audits.

The agency dropped a proposal to bar fees for services that are not performed, though, such as compliance expenses or costs defending against regulatory probes. In this final rule, the SEC substituted disclosure requirements for outright bans on some preferential treatment and some controversial fees.

Private fund liability

And there was no change made to private fund liability rules; the agency’s original plan would have allowed investors to sue for “negligence” rather than “gross negligence”.

The SEC had initially proposed banning so-called “side letters”, an industry practice through which funds can offer some investors special terms, but it opted yesterday to require that fund managers disclose such agreements when they are financially material instead.

The SEC did, however, ban the practice of offering some investors special redemption terms.

To meet the concerns of private funds and the contracts they already have in place, the SEC said it would not require advisers and investors to renegotiate governing agreements for existing funds.

Fund advisers will have a year to adopt the rule’s requirements – unless they manage less than $1.5bn, in which case they will have 18 months to catch up to certain of the rule’s provisions.

The agency said that adopted legacy status provisions remain applicable to certain restricted activities and preferential treatment provisions – mainly the governing agreements that were entered into in writing prior to the rule’s compliance date and with respect to funds that have commenced operations as of the compliance date.

Speaking of compliance dates: Fund advisers will have a year to adopt the rule’s requirements – unless they manage less than $1.5bn, in which case they will have 18 months to catch up to certain of the rule’s provisions.

Private fund landscape

The private fund space is growing rapidly. Two-thirds of new private market investment came from North America last year, according to a McKinsey study. The net assets reported on Form PF tripled from 2013 to the third quarter of 2022, and between the year 2000 and 2021, private equity global assets under management grew at four to five times faster than the overall US economy.

And private capital reaches nearly every corner of the markets, through its ownership of real estate companies and hospitals, infrastructure and energy firms and agricultural businesses.

As Commissioner Caroline Crenshaw notes in her statement supporting the rule, working and retired US public pension plan beneficiaries, such as teachers, firefighters, law enforcement, and government employees, are likely to have exposure to private funds and their portfolio company investments.

The SEC said in its rule proposal that, given such marked growth, it needed (via greater disclosure obligations) to collect more current data on the market and how advisers and investors interact to better assess systemic risks, market weaknesses, and potential areas for investor harm.

Industry groups

Since the proposed amendments were first unveiled 18 months ago, private funds and their affiliated trade groups have battled back, sending comments and telling Congressional lawmakers that the rules will hurt smaller businesses, such as those owned by women and minorities, and calling the rules “arbitrary and capricious”.

Speaking of the impact on London-based fund managers before the final voting yesterday, Marc Elovitz, partner at Schulte Roth & Zabel said those managers that have US investors will be subject to these rigid rules. “It could cut US investors off from a lot of these funds,” he said.

“This is trying to make private funds more like registered funds.”

Elizabeth Shea Fries, partner at Sidley

“We will be focusing on its potential to stifle innovation and harm the economic environment for venture and start-ups,” said Bobby Franklin, chief executive of the National Venture Capital Association.

The new rules would impose “significant costs” and big changes on the industry, said Elizabeth Shea Fries, partner at Sidley. “This is trying to make private funds more like registered funds.”

Brian Daly, a partner at Akin Gump who advises hedge funds and private-equity funds, said it is unclear if the changes will dissuade industry groups from suing the SEC. 

The specter of lawsuits might loom larger in the near term, as some private funds, especially private-equity and venture-capital funds, have not been doing so well. They tend to invest in illiquid companies and a number of them are just now starting to show their exposure to last year’s downturn in the financial markets.

Commissioner Mark Uyeda issued a dissenting statement calling the final rules arbitrary and capricious, saying they impose rules for private funds – products that are generally available only for sophisticated investors – that are far more burdensome and restrictive than those products for retail investors.

Commissioner Hester Peirce dissented from the rulemaking as well, submitting a bluntly worded statement that called the rulemaking “ahistorical, unjustified, unlawful, impractical, confusing, and harmful”. She says private fund investors are sophisticated institutions and institutional investors, such as university endowments and pension funds, are well represented by highly qualified professionals in their negotiations with private fund advisers.

Quoting from a comment submission, and referring to the private fund space’s growth over the last decade (which was mentioned many times by the three approving commissioners as a cause for alarm), she says “the private markets have thrived – in spite of the self-interested practices described in the Commission’s Proposal – because in many instances, investors have been well-compensated for their risks.”

Both Commissioners Uyeda and Peirce consider the rulemaking to be unlawful and not based on any clear statutory basis or authority.

Consumer-focused groups

Consumer groups have said the proposal would improve accountability and transparency in a sector that not seeks money from very wealthy individuals – but also receives a large flow of cash in the form of public pension money.

“This industry is full of conflicts and shady side agreements. The private fund advisers are making a killing in the shadows,” said Dennis Kelleher, chief executive of Better Markets, a financial reform group.

After Wednesday’s vote, the reform group said this version marked an improvement, but it still left investors in private funds exposed to shady practices. 

“This industry is full of conflicts and shady side agreements. The private fund advisers are making a killing in the shadows.”

Dennis Kelleher, chief executive of Better Markets

A letter signed by a group of Democratic senators earlier this year called on Chair Gensler to greenlight the originally proposed Form PF amendments because (among other reasons) the new rules will alert regulators of market disruption, such as the January 2021 market volatility in “meme stocks,” and March 2022’s volatility in the fixed-income markets, each of which caused sizeable losses at hedge funds with wrong-way bets and even some fund closures.

And SEC Chair Gary Gensler said the new rules were consistent with the agency’s mission and Congressional mandate, and they were crafted “on behalf of all investors – big or small, institutional or retail, sophisticated or not”.

Author’s Note: The new rules state that the annual audit requirement for private funds can be satisfied using requirements consistent with the current custody rule, rather than through a new set of requirements as proposed. With that in mind, the SEC on Wednesday also reopened for public comment its February 2023 safeguarding proposal.

This article was updated on August 24 to include comments from Commissioners Peirce and Uyeda.