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SEC proposals redefine regulation for private funds

For real estate managers, new rules would require additional fee disclosures and provide less flexibility in dealing with investors.

The SEC: taking a harder look at private funds.

The Securities and Exchange Commission’s sweeping proposals to re-examine the way private funds are regulated and alter the way managers engage with investors are both a cause for celebration and concern.

One proposal, issued in January, called for managers to disclose more information to the SEC about their activities through Form PF. The other proposal, issued in February, would establish a new set of rules and restrictions relating to private funds.

Industry groups and compliance experts say the proposals would shift the SEC’s oversight role from one based largely on disclosure requirements to a more interventionist approach.

Gensler: more transparency is needed from the private funds market

Managers and their service providers are particularly concerned by the agency’s efforts to standardize the industry in ways that undercut long accepted operating procedures. This includes restrictions on what fees can be charged to a fund or its portfolio companies, borrowing practices, performance reporting and waivers of liability. Those items have traditionally been incorporated into limited partner agreements or negotiated on an investor-by-investor basis.

In fact, one proposal seeks to curb the practice of granting preferential treatment to certain investors. Such agreements could continue in side letters, but only if the details are disclosed to all other investors.

“It goes far beyond promoting transparency,” one industry advocate tells PERE. “[The SEC is] taking it beyond being a disclosure regime and getting involved as if they were an LP on certain issues. I don’t think that’s the appropriate place for the SEC to go.”

Investors, on the other hand, have applauded both sets of changes for addressing longstanding concerns about transparency, governance and alignment of interests between managers and investors.

“These proposed rules would importantly help address the increased prevalence of conflicts of interest in the industry, ensure that investors can validate that fees and expenses they are charged match what was contractually agreed and deter practices that feed misalignment, such as ‘shifting’ liability risk from private fund advisors to investors,” Steve Nelson, chief executive of the Institutional Limited Partner Association, a trade group for institutional investors, said in a statement.

Impact on real estate

For real estate funds, especially those focused on value-add and development strategies, a new rule requiring detailed quarterly reports on fees and expenses would prove especially burdensome, Greg Larkin, a Washington, DC-based partner of the law firm Goodwin Procter, tells PERE. Fees vary greatly depending on the firm and lifecycle stage of its investment strategy, he says, so it would be difficult to make direct comparisons between funds based on a moment in time.

“People do get disclosures on the types of fees and expenses that are being charged to them and aggregate levels of what those are,” Larkin said. “Breaking them down into different buckets might be more confusing and, ultimately, not very useful for investors.”

Prohibited activities rule: The SEC’s latest proposed rule change for private funds would restrict managers from: 

  • Charging certain fees and expenses to a private fund or its portfolio investments, such as fees for unperformed services (ie, accelerated monitoring fees) and fees associated with an examination or investigation of the adviser
  • Seeking reimbursement, indemnification, exculpation or limitation of its liability for certain activity
  • 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

Since investors typically do not have redemption rights in closed-end funds, Larkin questions the relevance of such disparate information to potential future investors: “The SEC says it’s for comparing, but why is it being done on quarterly basis? If you’ve got a closed-end fund, it’s not entirely clear what investors are supposed to be doing with that information.”

New rules on manager-led secondaries and recapitalizations could also have a direct impact on the private real estate funds market, in which such transactions are becoming increasingly common. The SEC has called for managers to have outside groups compile a fairness opinion report that looks at both the economic impact of a secondary sale and the manager’s relationship with any new parties brought into the fund.

Larkin says this is already common practice for most large managers, so he does not see it creating new burdens on the industry. However, he notes that the SEC has indicated a concern that manager-led secondaries are being executed against the best interests of investors, meaning more regulation on that front could be imminent.

Systemic risk?

A common question raised is whether the SEC’s twin proposals are geared more toward limiting financial system risk or simply gathering information to develop new regulations.

In its first private fund rule change proposal in January, the SEC called for fund managers to report more information about specific strategies they are pursuing; their use of leverage; how they are financing portfolio companies; their controlled portfolio companies and related borrowings; their investments in different parts of a single portfolio company’s capital structure; and their restructurings or recapitalizations of portfolio companies.

“Those issues don’t appear to be things that are really going to point to systemic risks,” said Jason Mulvihill, chief operating officer of the American Investment Council, an industry group for private fund managers.

SEC chairman Gary Gensler has made private fund reform a key part of his agenda since being appointed head of the agency last year. In his endorsement of the most recent set of proposed rule changes, Gensler noted that private funds collectively manage $18 trillion of gross assets, largely on behalf of pensions. Given this size and reach, the activities of private funds are inherently of interest to the broader public, he argued.

“Private fund advisers, through the funds they manage, touch so much of our economy,” he said. “Thus, it’s worth asking whether we can promote more efficiency, competition and transparency in this field.”

Yet, even within the SEC there is doubt as to whether the proposed rules are the best way forward. Commissioner Hester Pierce, the lone dissenting vote against the amendments, called them a “sea change” and a “meaningful recast of the SEC’s mission.” Pierce argued that the investors capable of accessing private equity funds are sophisticated enough to safeguard their own best interests and that enforcing the new rules would be taxing on the agency’s budget.

Ultimately, she said the new rules would have a chilling effect on the market: “This proposal, if finalized, could hinder capital formation.”

The proposals will be open to public comment for 60 days, but with three of the four SEC commissioners endorsing the new rules, they are likely to be adopted largely as is. Larkin says these new regulations confirm the industry’s worst concerns about the Gensler regime. “It’s hard to not view this as a hostile environment for private funds,” he said.