Have recent proposals foreshadowed a fundamental change to the regulation of private funds in the United States, including the alignment of private fund regulation with that of Registered Investment Companies (“RIC”) for retail distribution? According to Daryoush Niknejad, General Counsel of the Sanne Group, the proposed regulations of 2022 take a strong step in that very direction.
In the recent blog post “SEC proposals aplenty, the “RIC-ification” of private funds and the impact on clients”, shared below, Niknejad breaks down the proposed regulations and their impact.
On September 27, 2021, the Securities Exchange Commission (“SEC”) Asset Management Advisory Committee published recommendations (“Recommendations”) which felt like a remnant of the previous administration—proposals to open private funds to retail investors.
Sanne published an article outlining them, but also highlighted “headwinds,” including a new U.S. President and SEC Chairman, Gary Gensler, who were likely to be wary of, if not more hostile to, the industry. Since the start of the year, a slew of new and meaty proposed regulations on the private fund industry seemed to verify that analysis, however, in hindsight, we may have missed in those liberal Recommendations a preview of what may turn out to be the start of a fundamental change to the regulatory treatment of private funds in the U.S.
One premise of the Recommendations was to align the regulation of private funds with that of Registered Investment Companies (“RIC”) for retail distribution. The proposed regulations of 2022 take a strong step in that very direction. They include increased and frequent reporting on securities positions and certain portfolio events, broad disincentives and prohibitions against treating various classes of investors differently, and efforts to reduce the cost (and thus profitability) of private funds. Taken as a whole and with the expectation of more to come, we appear to be moving in a direction where private funds, which are designed for the most sophisticated of investors with bargaining power, are regulatorily looking like RICs, but with a more restricted investor base—i.e., accredited investors, qualified clients, and qualified purchasers.
Below, Niknejad summarizes the proposed regulations in two ways—by outlining the most impactful proposals on Sanne’s clients, and providing a fulsome review of all proposed regulations.
Amendments to the Investment Advisers Act of 1940
On February, 9 2022, the SEC proposed a vast array of new rules and amendments to the Investment Advisers Act of 1940 (the “Advisers Act”). Some of these proposals are tasks Sanne’s clients already perform (i.e., annual fund audits, periodic written fund statements, and written annual compliance review) or can easily achieve via an existing service provider (e.g., reporting on certain fees and expenses, which can be added to administrator statements).
According to Niknejad, the most impactful of these proposals are the “Prohibited Activities Rule” and the “Preferential Treatment Rule”. The former will likely increase costs to the adviser, while the latter will likely require a fundamental change to the operations of most advisers. Notably, they apply whether the adviser is SEC-registered or not, including state-registered advisers and exempt reporting advisers.
Prohibited Activities Rule. All private fund advisers would be prohibited from:
- Charging certain fees and expenses to a private fund or its portfolio investments, such as fees for unperformed services (e.g., accelerated monitoring fees) and fees associated with an examination or investigation of the adviser
- Seeking reimbursement, indemnification, exculpation, or limitation of its liability for breaches of fiduciary duty and other threshold events
- Reducing the amount of an adviser clawback by the amount of certain taxes
- Charging fees or expenses related to a portfolio investment on a non-pro rata basis
- Borrowing or receiving an extension of credit from a private fund client
Niknejad notes that these put a squeeze on profit centers and limit the ability to pass costs to the fund and its investors. Perhaps most significant is the inability to receive certain indemnities/limitations of liability. Virtually every fund Limited Partnership Agreement (“LPA”) and Private Placement Memorandum PPM (“PPM”) today contains some indemnity and limitation of liability in favor of the adviser and general partner. Firms will have to go back to their law firms to update those documents, which is just the upfront cost. The back-end cost is even greater due to the resulting heightened litigation risk and the likely rise in the cost of insuring the adviser.
Prohibited activities rule. The proposal prohibits all private fund advisers from providing:
- Preferential redemptions terms from the fund;
- Preferential information about portfolio holdings or exposures;
- Any preferential treatment that has a material, adverse effect on other investors; or
- Other preferential treatment unless disclosed to current and prospective investors.
Niknejad points out that most advisers treat investors differently for various reasons or no reason at all. Almost all advisers treat the GP or employee investment vehicles differently, including allocation of fees, expenses, and the requirement to contribute capital. Fundamentally, the rule would require the adviser to look at every agreement, side letter, report/statement, or practice for all investors (including the GP) originating in every department, including marketing, portfolio management and investor services, to identify the ones that might have a “material negative effect” on other investors (and would therefore be prohibited. Any new practices would be subject to a similar analysis and approval process. At the moment, there is no guidance as to what “material, negative impact” means.
And “disclosure” does not appear to mean the more general kind to which advisers are accustomed. For example, simply saying some investors may pay different amounts based on the investment size won’t do. The SEC states that instead, the adviser must describe the specific fee terms, which would naturally create some fee pressure from similarly situated investors.
The proposal also makes certain “preferential treatment” impermissible on its face, such as preferred liquidity/redemption rights or more frequent portfolio information (a practice that is common but created issues in the great recession when some investors had early warning information about a fund and the ability to get out quickly).
The proposed Advisers Act rules should also be read in parallel with the SEC's Division of Examinations' Risk Alert, highlighting four key topics for private fund advisers to consider regarding their fiduciary duties. Read a summary of the proposals from Sanne in a recent article here.
In the article Niknejad also provides guidance on Amendments to Form PF, cybersecurity risk management for investment advisers, short position and short activity reporting by institutional investment managers and Beneficial Ownership. You can read the full post here.
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