Travers Smith's Alternative Insights: SEC proposal for private funds

A regular briefing for the alternative asset management industry.

It is no surprise that the US Securities and Exchange Commission – now led by Gary Gensler, the Chair appointed last year by the Biden administration – has made proposals to increase the regulation of private fund managers (or "investment advisers"). But perhaps it is surprising that that the rules proposed earlier this month could have an important impact on many European firms, as well as those in the US.

While there is likely to be significant market push-back to some of the mooted rule-changes which, among other things, challenge well-established and heavily negotiated risk allocations agreed with sophisticated investors, the SEC seems to be signalling that protection of institutional investors is now firmly within its remit. And, importantly, non-US "exempt reporting advisers" (or ERAs) are in scope of some of the most dramatic changes.

Many non-US firms who raise funds from US investors are classified as exempt reporting advisers because they have their principal place of business outside of the US, their only US "clients" are private funds, and all assets managed by the firm from a location in the US (if any) are solely attributable to private funds and total less than $150 million. ERAs must make regular public SEC filings containing a limited amount of information (at least annually), and are subject to a reduced set of SEC rules.

Some of the most controversial proposals made by the SEC – specifically, the changes that are included under the headings "Preferential Treatment" and "Prohibited Activities" – would apply to all private fund advisers, including ERAs, with no grandfathering for existing funds.

The "Preferential Treatment" rule would prohibit certain arrangements with particular investors (for example, in a side letter) that the SEC regards as detrimental to other investors in the fund, such as preferential redemption and transparency rights that would have a “material negative effect on other investors in the private fund”. The Preferential Treatment rule would also require additional disclosure of other preferential terms, with that disclosure being provided pre-commitment to prospective investors, and annually to existing investors.

The proposed "Prohibited Activities" include a range of activities and contractual provisions that the SEC has deemed to be “contrary to the public interest” and would include, for example, a prohibition against any clawback of overpaid carried interest being limited to the net after-tax amount; and a prohibition on indemnification by the fund or its investors for the adviser's negligence.

These and other proposed changes would, if implemented, force a change to market practices in both European and US private funds and would require changes to existing (negotiated) contracts. And, while many of the other changes outlined in the SEC's proposals will only affect investment advisers that are registered with the SEC (and not ERAs), those changes would also add significant additional reporting, disclosure and compliance requirements for those firms.

...these proposed rules, if adopted in their current form, would mark a significant change in regulatory strategy by the SEC and restrict the ability of sophisticated market participants to decide for themselves the rules that should apply to their relationship...

One change – though not one applicable to ERAs – that has caught the attention of the secondaries community is the proposed requirement for a "fairness opinion" on a GP-led secondary transaction. The SEC claims that this is "an important check against an adviser’s conflicts of interest in structuring and leading a transaction from which it may stand to profit at the expense of private fund investors".

In fact, of course, fairness opinions are fairly standard in the US (and European) market as a way to manage the unavoidable conflicts of interest that arise on a secondary deal that is initiated by the private equity fund sponsor, including when the manager wants to offer investors an opportunity to continue to hold one or more assets while giving others the chance to achieve liquidity. The fund's LPAC (Limited Partner Advisory Committee) will have a significant role in managing these conflicts; indeed, their consent to the transaction is typically required under the fund's partnership agreement. Since LPACs regularly include representatives from some of the world's largest and most sophisticated investors, it is not surprising that good practices have become industry-standard. Investors also have the benefit of the ILPA Guidance, which is soon to be updated to take specific account of the growth in single asset continuation funds.

The problem with the SEC's proposed rule, though, is its rigidity: there will be times when a fairness opinion is not needed, because (for example) a current open market valuation of the asset is available. If the LPAC is comfortable with that, it is not obvious what a fairness opinion will add – except an additional cost to be borne by the fund (and, therefore, the investors).

Perhaps more newsworthy, though, is that the SEC appears to be focused on GP-led secondary deals at least in part because it sees them as an indication that a GP is unable to sell assets and, therefore, as a sign of potential trouble ahead. They made this point in a separate consultation, issued at the end of January, on changes to Form PF – the filing required to be made by private fund advisers – proposing that a firm must notify the SEC immediately on completion of any GP-led secondary, rather than when the next filing is due.

While the SEC's view was a common stereotype of GP-led deals in their early days, today GP-led secondaries are often centred around prized assets in which the sponsor sees significant room for future growth. It is not clear how the SEC would be able to tell the difference between a continuation fund deal that signals a difficult market, and one where the GP thinks a crown-jewel asset has significant upside that it does not want to forgo.

All told, these proposed rules, if adopted in their current form, would mark a significant change in regulatory strategy by the SEC and restrict the ability of sophisticated market participants to decide for themselves the rules that should apply to their relationship. Non-US managers that are ERAs, and certainly non-US managers that are registered with the SEC, should pay careful attention to further developments.

We are grateful to Lindsey L. Wiersma, Partner at Paul, Weiss, Rifkind, Wharton & Garrison LLP for help in preparing this edition of Alternative Insights. Further information on the SEC's proposed changes is available here.

Last year we hosted a webinar on GP-led secondaries. Request a copy of the recording.

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