Investment advisors and their organizations have been fighting a proposed rule that would increase disclosure requirements and scrutiny of private fund advisors.
With just days left of the extended comment period, more than 230 letters have been submitted to the Securities and Exchange Commission over its “Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews.”
After an appeal from congressional members of both parties to give adequate time to review the 341 pages and 943 questions in the proposal, the SEC extended the original 32-day period to June 13.
In proposing the changes in February, the SEC said it is protecting private fund investors by increasing transparency, competition and efficiency in the $18 trillion marketplace.
According to a Faegre Drinker analysis, the rules would add quarterly reporting requirements, fund audit requirements, independent fairness opinion for advisor-led transactions, six newly prohibited activities, prohibitions and requirements regarding preferential treatment, and requirement to document the annual rule 206(4)-7 review in writing.
“The SEC also noted several instances of conflict of interest that involve problematic sales practices or compensation schemes, instances where advisers seek to limit their fiduciary duty and the general lack of strong governance at private funds,” according to the analysis.
Many of the comments submitted to the SEC come from pension funds, consumer groups and individual investors in support of the rules, saying that investors are left at an unfair disadvantage, especially at a time when more institutional and private investors are seeking alternative investments from hedge funds to improve returns.
In announcing the rule changes in February, SEC Chair Gary Gensler said, “Private fund advisors, through the funds they manage, touch so much of our economy. Thus, it’s worth asking whether we can promote more efficiency, competition, and transparency in this field. I support this proposal because, if adopted, it would help investors in private funds on the one hand, and companies raising capital from these funds on the other.”
Association asserts overstepping
The Securities Industry and Financial Markets Association – Asset Management Group (SIFMA-AMG) said in a 77-page letter that the SEC was overstepping its authority with its new rules.
According to SIFMA, the proposal would harm investors by increasing the cost of accessing private funds, limiting investors’ ability to invest in funds that have generated strong returns and restricting privately held companies’ capital formation opportunities arising from private funds. The proposal would also inhibit competition in the fund industry by increasing the barriers to entry for new advisers and could force the consolidation of smaller firms.
Specifically, SIFMA said the rules would:
- Require that SEC-registered investment advisors to private funds provide investors with quarterly statements on private fund performance, fees and expenses.
- Require private fund RIAs to obtain an annual audit for each private fund and compel the private fund’s auditor to notify the SEC upon certain events.
- Require private fund RIAs, in connection with an adviser-led secondary transaction, to give investors a fairness opinion and a written summary of certain material business relationships between the advisor and the opinion provider.
- Prohibit all private fund investment advisors, including those that are not SEC-registered, from engaging in certain activities and practices that the SEC has deemed to be contrary to the public interest and the protection of investors.
- Prohibit all private fund investment advisors from providing preferential treatment that have a material negative effect on other investors, while also prohibiting all other types of preferential treatment unless disclosed to current and prospective investors.
Additionally, the SEC is proposing to require all RIAs, including those that do not advise private funds, to document the annual review of their compliance policies and procedures in writing.
Whose fiduciary duty?
A recent case settled between the SEC and Allianz SE illustrates how much damage can occur when oversight is lax.
Allianz agreed to pay $6 billion to settle charges that its investing division defrauded investors by hiding losses and risks that led a hedge fund to collapse during the 2020 market meltdown. The collapse wiped out pension funds of more than 100,000 people.
Pension funds and other institutional investors are among the key supporters of the rule. The Institutional Limited Partners Association (ILPA) represents 585 institutional investors holding more than $2 trillion in private equity assets, which the association said is critical to generating “required investment returns.”
The rule would “restore fiduciary duty” by requiring private fund advisors to be held to a fiduciary standard similar to that of their investors, “who themselves invest in private funds as fiduciaries on their beneficiaries’ behalf,” ILPA said in its comment.
“Private equity has delivered enormous long-term financial benefits to LPs [limited partners], and by extension, the millions of people and essential programs they serve,” ILPA commented. “The investment and operating model is not, in our view, fundamentally flawed or irreparably broken. However, market forces have, over the past decade, eroded elements of the partnership between LPs and advisors.”
ILPA’s larges member also submitted comments: California Public Employees’ Retirement System (CalPERS), the largest public defined benefit pension fund in the United States, managing $470 billion in assets for its 2 million members.
CalPERS and ILPA endorsed most of the rule change, with refinements, but they raised a flag on the “preferential treatment” portion. While supporting greater transparency, CalPERS said the proposal limiting “side letter” preferential agreements would be problematic.
“CalPERS considers side letters important, as a means of securing critical governance, statutory, and regulatory protections that otherwise may not be included in Limited Partnership Agreements,” according to the letter. “We urge the Commission to provide greater specificity as to the nature of terms deemed to have a material, negative impact on other investors in the same fund. Further, we request that the SEC clarify that this rule does not prohibit investors from entering into bespoke arrangements with private fund advisers to secure essential institution-specific requirements.”
What RIAs can do
The rule is widely expected to be adopted with changes. Analysts at Faegre Drinker advised firms to be prepared with some practice tips:
- Consider how to comply with some of the more difficult parts to implement, including requirements focused on reporting and allocation of fees and expenses — and valuation in support of performance reporting.
- Prepare for higher compliance and financing costs if the proposal is implemented, even in a revised form. Consider expanding compliance and finance departments.
- Get ready for more examinations and enforcement actions. Start thinking about implementing extensive compliance training programs for employees.
- Pay close attention to the several carefully drafted definitions that may or may not be in line with industry norms. Understand the defined terms to prevent any misunderstanding of what would be expected under the rule.
Steven A. Morelli is a contributing editor for InsuranceNewsNet. He has more than 25 years of experience as a reporter and editor for newspapers and magazines. He was also vice president of communications for an insurance agents’ association. Steve can be reached at [email protected]
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