Private fund advisers, including those that manage venture capital and private equity funds, will be forbidden from passing along the costs from investigations unless they obtain informed consent from their investors, and they’ll have to disclose any fees or expenses for the costs of exams, enforcement or other compliance matters under new rules adopted today by a divided SEC.
The new rules maintain many of the controversial prohibitions laid out in the proposals from last year, but they give advisers a little wiggle room with grandfather clauses and rigid disclosure requirements. For instance, under the new rules, private funds won’t be allowed to:
- Charge non-pro-rata, portfolio-level fees or expenses “unless the allocation approach is fair and equitable and the adviser distributes advance written notice,” including a description of “how the allocation approach is fair and equitable.”
- Use their tax bills to reduce clawbacks “unless the adviser discloses the pre-tax and post-tax amount of the clawback to investors.”
- Borrow or receive credit extensions from private fund clients “without disclosure to, and consent from, fund investors.”
The prohibitions apply to all private funds, registered or not. Registered investment advisers in particular must adhere to four new rules. For example, they must “document in writing” a newly required annual review of their compliance policies and procedures, as well as any of their program’s failures. Also, registered private fund advisers now must give their investors quarterly statements explaining fund performance, fees and expenses, audit each fund every year and obtain a fairness or valuation opinion on any secondaries deal they lead.
Only VC firms that are registered investment advisers must abide by the new quarterly and annual reporting rules. Those firms include many of the industry’s biggest names, such as Andreessen Horowitz, Insight Partners and Sequoia Capital, according to Venture Capital Journal research. The vast majority of venture funds are exempt reporting advisers, so the new quarterly and annual reporting rules do not apply to them. (See VCJ‘s list of VC firms that are registered investment advisers.)
Among the changes under the new rules, private funds will no longer be able to offer “preferential terms” to investors in redemptions (“unless the ability to redeem is required by applicable law or the adviser offers the preferential redemption rights to all other investors without qualification”), or by giving some investors details about portfolio holdings or exposures (“unless such preferential information is offered to all investors”). “In addition,” regulators add in a new fact sheet, “this rule prohibits all private fund advisers from providing preferential treatment to investors, unless certain terms are disclosed in advance of an investor’s investment… and all terms are disclosed after the investment.”
The new rules offer “legacy status” for prohibited activities/preferential treatment regulations, “if the applicable rule would require the parties to amend the agreements.” That is a concession to industry: More than one private fund advocate warned the SEC that its proposal was dangerously close to violating the Constitution’s ban on ex post facto laws because it would require funds to tear up existing agreements.
Supporters say the new rules will bring some much-needed daylight into a $25 trillion industry that has become too big to fail. Given the millions of ordinary Americans who find their pensions tied to private funds, supporters say, regulators need a closer look at the opaque business.
“Private funds and their advisers play a significant role for investors and issuers. They play an important role in nearly every sector of our capital markets,” SEC Chairman Gary Gensler said in supporting the new rules. “Standing behind those entities are millions of investors like municipal workers — that’s the teachers, firefighters, professors, students, and more.”
‘Ahistorical, unjustified, harmful’
Republican commissioners Hester Peirce and Mark Uyeda condemned the new rules. The rules are “ahistorical, unjustified [and] harmful” and uproot decades of congressional and jurisprudential attitude toward private funds, Peirce said in her dissent.
“We’re adopting a prescriptive regime that edges out contractually negotiated ground rules,” she wrote. “As long as investors understand the terms of what they’re investing, why should the government care what those terms are? In the name of fostering competition, we’re squashing it.”
The new rules take effect 18 months after they appeared in the Federal Register. As the commission was weighing its two votes on August 23, it reopened its proposed safeguarding rules for comment.
To sue or not to sue
Industry has fought the new rules tooth and nail. Beginning in late July, as word of the new rules made its way through Washington, representatives from the Managed Funds Association, the Investment Adviser Association and Goldman Sachs met with commissioners and their staff, SEC lobbying records show. Many groups brought in trial lawyers to write letters during the comment period, a subtle message that Gensler wouldn’t have missed. The question now is whether Gensler has softened his proposals enough to avoid a court challenge.
In an email statement, MFA president and CEO Bryan Corbett said his group is weighing “appropriate next steps.” The MFA “continues to have concerns that the final rule will increase costs, undermine competition and reduce investment opportunities for pensions, foundations and endowments,” Corbett wrote.
Anyone who wants to challenge these new rules in court got an immediate vote of confidence from U.S. Rep. Patrick McHenry, R-N.C. He chairs the House Financial Services Committee and is a longtime Gensler critic. “Once again,” McHenry said in an email statement, “Chair Gensler’s SEC is exceeding its statutory authority to impose onerous and costly mandates — this time on private funds. By applying a framework designed for retail funds used by everyday investors to private funds, this rule fails to acknowledge the differences between these markets.”
Lawrence Aragon contributed to this story