17 May 2024 What General Partners Should Know About New Private Fund Rules
Authored by RSM US LLP, May 17, 2024
On Aug. 23, 2023, the U.S. Securities and Exchange Commission (SEC) adopted new rules and amendments for private fund advisers under the Investment Advisers Act of 1940, ushering in significant regulatory changes in the private fund industry.
As the private fund adviser rules will likely affect all private fund operations, general partners (GPs) should understand the impetus for the change and what it means for them. Here is the gist of the new rules and the expectations for the industry.
Understanding the fundamental objectives of the new rules
Since the beginning of his tenure at the SEC, Chair Gary Gensler has expressed his view that the size and complexity of private markets today may warrant an enhanced reporting and disclosure regime. Those intentions have played out through the SEC’s new private fund adviser rules, along with a host of other rules that the SEC has proposed or adopted over the past three years.
The SEC has said the private fund adviser rules, specifically, are designed to address a number of risks and harms to investors, including a lack of transparency, conflicts of interest, and a lack of certain governance mechanisms. Ultimately, the rules are designed to address these risks by increasing transparency, competition and efficiency in private markets.
Five key provisions will affect private fund managers. The first is a new quarterly statement rule. Then there is a new audit requirement affecting all funds managed by regulated investment advisers; around 90% of private equity funds are already audited, but this is going to be a significant undertaking for the remaining 10%.
A fairness opinion will be required whenever an adviser-led secondary transaction takes place, and there are also new restricted activities provisions designed to limit managers’ ability to allocate certain fees to funds without disclosure, or in some cases only permitting the allocation where explicit consent has been given by investors. The final provision involves preferential treatment, whereby firms will have to disclose all preferential terms—including those contained in side letters—to all current and prospective limited partners (LPs).
The potential impact on GP operations
The reporting requirements will have ramifications across the advisers’ entire organizations. There will be a direct impact on the accounting and operations teams due to changes in the way they track and process information to provide the granularity now required in these reports. When it comes to reporting metrics around historical performance such as the internal rate of return (IRR) and multiple on investment capital (MOIC), that may mean retrospectively changing the way information has been recorded over many years to ensure that the data required to produce these reports is available in a usable format.
Of course, the reporting and investor relations (IR) functions will also be affected. There are not only new requirements around what is reported but there are new timelines being enforced as well. Historically, the timing of reports was dictated by the limited partnership agreement, and in some cases, things slipped a little. Those timelines have now been prescribed by the SEC and will provide more accountability to meet these timelines.
There is also a lot more information that IR professionals will now need to fully understand so that they can adequately educate LPs on the new reporting processes and what this new information means for them. Finally, in some instances, the front office may feel the impact of the new reporting requirements too. For example, if a private fund manager is working on a deal involving a charge that would have been historically allocated to the fund, but no longer can due to the restricted activities provision, it may change the underwriting.
Private fund managers should consider what operating model they need today and in the future, and how to leverage external strategic partners to add scalability and efficiency.
How technology can help alleviate additional workload
For well over a decade now, private fund managers have had to confront myriad additional reporting requirements stemming from demands for data transparency from the Institutional Limited Partners Association (ILPA) and the SEC. As a result of these reporting demands, powerful industry technology has been developed and adopted by many in the alternative assets industry.
Technology plays a pivotal role, as it enables private fund managers to capture a wide range of granular data relating to their portfolios, fund structures and operations. Today’s best technologies provide powerful data analytics, customizable investor portals and GP dashboards, and also streamline critical operational business functions. These technology-induced benefits play a critical role in decreasing risk and increasing efficiency for asset managers.
What managers can do to maintain compliance and operational efficiency
Having additional reporting requirements will inevitably affect operational efficiency. To help alleviate the burden, private fund managers can leverage more advanced technology and outsource particular tasks.
Additionally, private fund managers should consider what operating model they need today and in the future, and how to leverage external strategic partners to add scalability and efficiency. Ensuring that operating models are and will remain fit for purpose is essential.
How the new rules will enhance transparency and communication with investors
Investors want to understand fund portfolio holdings, expenses and performance. The new rules offer them an unprecedented level of transparency and comparability in each of these areas.
When it comes to portfolio holdings, investors will receive audited financial statements including a schedule of investments. They will also receive a new level of granularity around expenses including uniform fee and expense information relating to compensation being paid between portfolio companies and managers. Some of this reporting has been required under ILPA for many years; however, for firms that have not been reporting under ILPA standards, this may be the first time they will have to disclose this information.
The quarterly statements will require a host of performance disclosures, including seven different IRR and MOIC calculations, enabling investors to compare performance between current and prospective funds. The preferential treatment rule will provide a new level of transparency by allowing investors to see preferential treatment offered to certain LPs, such as preferred liquidity rights or information rights, as well as fee discounts and other terms negotiated in side letter agreements.
Naturally, investors will want to understand the additional disclosure and look to GPs for an explanation.
Potential changes or enhancements related to the rules that may be forthcoming
As soon as the new rules were adopted, a number of trade groups sued the SEC, claiming the regulator did not have the statutory authority to impose these rules on private fund advisers or that they hadn’t gone through the appropriate notice and comment process. Until this litigation has been resolved, no additional formal guidance from SEC staff is expected.
What could happen? Certain aspects of the rules may be pulled back or rescinded. Industry observers predict elements of the quarterly statement rule may be deemed an overreach by the SEC. However, since the rules were adopted, fund managers have reported that LPs are requesting additional disclosure including the full range of performance calculations, levered and unlevered. Therefore, it is recommended that GPs not take a wait-and-see approach and instead be proactive in responding to investor demands for increased transparency.
The takeaway
Starting with the global financial crisis of 2007–2009 and the resulting Dodd-Frank Act, private market regulations and LP demands for data transparency and granularity have steadily increased. This trajectory won’t change regardless of what happens in the courts over the SEC’s new private fund rules.
In the past, many private market firms have favored a lean approach to managing investor reporting; however, this strategy will no longer work as evolving reporting requirements become more stringent. To stay ahead of regulatory developments and the growing needs of investors, GPs should prioritize building a data management strategy and next-generation operating model that is scalable and flexible. Working with an experienced advisor can help.
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This article was written by RSM US LLP and originally appeared on 2024-05-17.
2022 RSM US LLP. All rights reserved.
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