SPRING UPDATE: Private Funds’ Operating Practices, Performance, and Fees
This update to an article we published in February 2022 includes highlights of the Securities and Exchange Commission’s (SEC) new proposed rules that will significantly impact reporting for private funds, following the SEC chairman’s recommendations last fall.
U.S. private funds currently manage over $18 trillion in gross assets. Given their size, the operations, trading activity and management of these funds can have a significant impact on all capital markets. However, only since the Dodd-Frank Act of 2010 has the SEC paid much attention to regulating these private funds. But times are a changing and private funds are back under the regulatory microscope.
In fact, in the latest example of this renewed attention, on February 9, 2022, the SEC announced proposed rules requiring that private funds provide additional disclosures to investors to increase transparency and guard against conflicts.
The SEC’s proposed rules would, for the first time, require funds to supply quarterly statements to investors detailing fund performance, fees, and expenses, as well as manager compensation. In addition, all funds would have to perform annual audits in an effort by the SEC to place a check on asset-valuation estimates often used to calculate fund managers’ fees. Investor-led secondary transactions would also require fairness opinions from an independent auditor. Last, the proposal would prohibit private fund advisers from engaging in certain practices deemed susceptible to conflicts of interest and areas of enhanced investor risk.
The SEC allowed for public comment until April 25, 2022, but just recently extended the comment period until June 17, 2022, after receiving widespread complaints from interest groups declaring there was inadequate time for a detailed analysis. So far more than 200 constituents have replied, including global accounting firms and law firms, multi-billion-dollar state pension plans, investment management firms, hedge fund associations, and anonymous public citizens. Comments ranged from full support of the proposed amendments and the SEC’s efforts to increase transparency and promote fairness among investors, to concerns over the additional costs investment management firms will bear to comply with the new reporting requirements. Institutional investors were particularly concerned about how these proposed rules would impact their ability to negotiate side letter terms and enter into bespoke arrangements with private funds to satisfy their institution’s specific needs.
The SEC’s increased focus on private funds has grown over the past year. Back in the fall of 2021 in his speech at the Institutional Limited Partners Summit, SEC Chairman Gary Gensler described the lens through which the SEC would question and examine the operations and fees charged by private funds:
- Are investors in private funds receiving adequate protections?
- Are fund managers implementing best practices for facilitating capital?
- Is the SEC creating regulations that ensure fair and efficient market operation?
Gensler tasked his Division of Examinations with developing rule-making recommendations based on the practices observed during examinations of registered investment companies and private funds over the past couple of years. Considering Gensler’s speech and the February 2022 announcement of the proposed rules, private funds should pay attention to and address the following areas to ensure compliance with current and potential SEC rules:
- Fees and expenses.
- Side letters.
- Performance metrics.
- Conflicts of interest.
- Form PF.
Fees and Expenses
Gensler called for funds to provide greater transparency around fees charged to investors. Fees that may need to be disclosed include not only management and performance fees, but also consulting, advisory, monitoring, servicing, transaction, and director’s fees, as well as fees collected from portfolio companies and others. These fees can significantly reduce net returns. For an investor to make an informed decision about where to invest their money, they need transparency on fees charged by the fund and/or manager.
On November 10, 2021, the SEC Division of Examination released a risk alert on the topic of fees charged by investment advisers. Specifically, examiners assessed:
- Accuracy of the fees charged by the advisers.
- Accuracy and adequacy of the advisers’ disclosures.
- Effectiveness of the advisers’ compliance programs and accuracy of their books and records.
Examiners observed several deficiencies that negatively impacted investors. For example, they observed advisers using percentages that were different from those contractually agreed upon. As a result, advisory fees were charged incorrectly. The report also found that incorrect investment valuations were used in calculating advisory fees. There were also inconsistencies related to the disclosure of information, including omitted disclosures regarding fee calculations; inconsistencies between advisory agreements and advisers’ brochures; or simply incorrect fees disclosed. Examiners found advisory firms lacked written policies and procedures related to advisory fee billing and monitoring. These inconsistencies impacted the accuracy of the financial statements that investors rely on to make informed decisions.
The proposed rules require private fund advisers to disclose, in a quarterly statement, the following fee and expense information to investors:
- A detailed accounting of all compensation, fees, and other amounts allocated or paid to the adviser or any of its related persons by the private fund during the reporting period.
- The amount of any offsets or rebates carried forward during the reporting period to subsequent quarterly periods to reduce future management fees or other payments or allocations to the adviser, or related persons.
Further, the proposal includes a prohibited activities rule that would prohibit an investment adviser from charging certain fees and expenses, including:
- Regulatory and compliance fees and expenses of the adviser or related persons.
- Expenses associated with any governmental or regulatory authority’s examination or investigation of the adviser or related persons.
- The adviser’s state licensing and registration requirements.
- The reduction of an adviser’s clawback of carried interest by actual or hypothetical taxes applicable to the adviser.
The last point is particularly harsh for private equity advisers who received and paid income taxes on carried interest distributions. For funds with a clawback obligation, it is a current industry practice to require the adviser to return only the post-tax performance-based compensation at the conclusion of the fund, if the advisor received more than the specified (typically 20%) carry over the life of the fund. The SEC, however, feels this practice puts the adviser’s interests ahead of investors’ interests. Even if the practice is disclosed, this compensation arrangement would result in investors unfairly bearing tax costs associated with the payment. Alternatively, the SEC suggests that advisers defer or otherwise delay payments if they do not wish to amend prior tax returns, particularly if there’s a possibility of a clawback. The adviser can escrow performance-based compensation instead of making a payment to its owners, which would allow the adviser to cover all or a portion of a pre-tax clawback obligation that may arise in the future.
Gensler noted that side letters needed more transparency. A fund adviser and certain investors may agree to terms that differ from those contained in the overall fund operating agreement; side letters provide investors with those negotiated terms. Examiners noted that side letters have been used to give preferential fees and/or liquidity terms or disclosures to certain investors. Creating favorable terms for some investors directly contradicts the idea that all investors should be or are treated equally by the fund advisor.
The proposed rules would prohibit side letters allowing preferential treatment that could negatively affect other investors, such as:
- Preferential redemptions.
- Providing selective information about the portfolio holdings or exposures of the private fund or a similar pool of assets.
- Other preferential treatment such as “excuse rights,” which allow certain investors to refrain from participating in certain investments.
In addition, the proposed rules call for advisers to disclose side letters to all investors by providing redacted copies or a written summary and description of the preferential terms provided to other investors in the same private fund.
Gensler mentioned the need for investors to be better informed about their investments’ performance metrics. It is not always clear to investors which fees and expenses are included or excluded when determining performance metrics. Enhancing this area would allow investors to more accurately compare similar fund strategies’ returns in different market environments and over time, and gauge the value of an adviser’s investment management services.
The proposed rules call for more standardized performance disclosure requirements on a quarterly basis, which would include annual returns from inception to date. A private fund, based on the definitions provided in the proposed rules, would be identified as either an illiquid or liquid fund, and it would present either an internal rate of return or total return performance metric information, respectively, depending on its categorization. Further, certain funds with complicated fund structures may need to provide adequate disclosure of the criteria used and assumptions made in calculating performance.
The SEC recognizes that some private funds may not neatly fit into the liquid or illiquid designations. For example, hybrid funds may trade in both marketable and private securities and have redemption rights and other characteristics of liquid and illiquid funds. Accordingly, the Commission is seeking feedback on the proposed definitions of “liquid” versus “illiquid” funds and whether to include a third category for hybrid funds.
Conflicts of Interest
Gensler remarked in his Nov 2021 speech that conflicts of interest between general partners, affiliates, and investors need to be better communicated and perhaps even prohibited at times. His concern stems from advisers’ increased attempts to waive their fiduciary duty. Private funds, in general, lack strong governance mechanisms to monitor and weigh in on conflicts of interest. Accordingly, their compliance programs take on added importance in protecting investors. The proposed rules include an amendment to the Advisers Act to require all SEC-registered advisers to document, in writing, the annual review of their compliance policies and procedures.
The fee disclosure requirements described above will also provide insight into several of the conflicts of interest some advisers face. For example, if a fund’s governing documents require the adviser to offset portfolio company fees they earned against management fees charged at the fund, investors will have more information to monitor the application of these management fee offsets or rebates.
The SEC is also concerned with the conflicts of interest that exist when fund advisors borrow from the fund or from their investors. This places the advisor on both sides of the transaction (i.e., the adviser benefits from the loan and manages the client lender) and causes conflicts when negotiating interest rates and other loan terms. The proposed rule would prohibit an adviser from borrowing money, securities, or other fund assets, or receiving a loan or an extension of credit, from a private fund client.
Gensler ended his November 2021 speech by discussing Form PF. The SEC adopted Form PF to establish reporting and recordkeeping requirements for private funds. The data obtained from Form PF is intended to help the SEC monitor private funds by collecting information about size, leverage, and investor types as well as concentration, liquidity, and fund performance. Gensler asked that the SEC find ways to improve the form.
As mentioned in our previous article, in January 2022, the SEC voted to approve proposed amendments to Form PF, which would hasten the reporting period, require additional information to be disclosed, and expand the scope of who must file Form PF.
The proposed rules consider further amendments to Form PF and Form ADV that would require advisers to report information about lending and borrowing practices with related parties and clients in conjunction with the proposals on borrowing described above.
Considering the current regulatory and political landscape, there will likely be significant changes to these proposed rules, the proposed amendment to Form PF, or other future regulation of registered investment advisors to private funds. The costs associated with change will be particularly impactful for small and emerging managers who may have limited resources to implement and adhere to the proposed rules. While the changes have yet to be approved and finalized, advisors should review the rules now and adjust their operations, policies, and practices accordingly.
All information cited in article is sourced from the following:
- Risk Alerts that Concern Private Funds (SEC Division of Examinations) – www.sec.gov/exams
- SEC proposed rules published by the Securities and Exchange Commission.