The private equity industry has reacted with alarm to sweeping new regulations introduced last month by the US Securities and Exchange Commission.
Keeping on top of compliance, regulatory requirements and individual obligations to investors are already major headaches for private funds. This compliance burden is set to become even more intensive once the regulations go into effect.
The new rules, running to more than 600 pages, are the most sweeping set of reforms for the private fund industry since the Dodd-Frank Act was passed in the aftermath of the 2008 global financial crisis.
The SEC argues that the new rules will protect investors by increasing transparency, competition and efficiency in the private fund market.
The industry maintains that the rules, even though watered down somewhat from what was originally proposed, will raise administrative costs, reduce competition and make it harder for institutions to invest in private funds.
On September 1, six US private equity and hedge fund trade groups sued the agency in a Texas court, arguing that it had overstepped its statutory authority.
New reporting requirements
With the objective of increased transparency, the final rules will require private funds to provide investors with quarterly statements detailing fund fees, expenses and performance.
Although most fund advisers already provide quarterly reports, the rules require standardised, detailed reports setting out line-item details of fees, expenses and additional compensation.
Fund advisers must also obtain and distribute to investors an annual financial statement audit of each private fund they advise as well as a fairness opinion or valuation opinion.
Restricted activities
The new rules prohibit fund manager activity that is "contrary to the public interest and the protection of investors". For example, managers will be prohibited from passing on the costs from investigations unless they have informed consent from investors.
They will also have to disclose any fees or expenses relating to exams, enforcement or other compliance matters.
Preferential treatment and side letters
Perhaps the most contentious and fought over aspect of the regulations relate to providing investors with preferential treatment.
The use of side letters to secure special rights for individual investors outside of the limited partnership agreement, which applies to all of a fund’s investors, has been growing in prevalence in recent years.
Preferential treatment contained in side letters could relate to fee discounts, specialist reporting information or securing seats on the fund’s advisory committee. Another popular provision is the inclusion of 'most favoured nation' clauses to guarantee an investor will obtain any favourable preferences granted to other investors.
The tracking and management of all these individual obligations is a major pain point for private funds, particularly as the volume and complexity of side letters has grown.
An academic paper published in the Washington University Law Review found that the average word count of side letters has risen from 639 (pre-2005) to 4,983 (post-2014).
