These reforms aim to increase transparency and oversight of the private fund industry, which has seen steady growth over the past decade.
The new rules require private fund managers registered with the SEC to:
- Provide quarterly statements to investors detailing fund performance, fees, expenses and adviser compensation. For example, the statements may show the fund’s return, management fees paid, legal expenses, and bonus compensation paid to the adviser.
- Obtain annual audits of the private funds they manage.
- Get a fairness or valuation opinion for adviser-led secondary transactions, such as GP-led continuation funds where advisers offer existing fund investors the option to sell or exchange their assets in another vehicle led by the adviser. This helps to provide an independent check for the limited partners (LPs) if they choose to swap into a new fund managed by the same adviser.
Additional reforms include:
- Restrict certain activities seen as contrary to public interest without disclosure or consent. For instance, managers cannot charge legal fees related to regulatory or compliance fees.
- Prohibit preferential treatment that negatively impacts some investors. For example, advisers cannot provide certain special access to portfolio information, favorable redemption terms compared to other investors, or, conversely, favorable fees to compensate for more illiquid share classes.
- Require registered advisers to document their annual compliance review.
According to the SEC, these tailored regulations will protect private fund investors by shedding light on practices that could potentially cause harm. The rules provide checks against advisers’ conflicts of interest and preferential treatment of investors (such as side-letters). It should also be noted that the finalized rules were softened compared to what was first proposed to the SEC. For instance, not allowing different fees and liquidity terms will only be required on new funds and share classes; existing structures will be grandfathered in. Still, a coalition representing large private equity and hedge fund managers moved to potentially block the new rules being implemented late last week. The SEC remains confident the rules will be finalized in the future.
We believe these reforms are a positive step to increase transparency and oversight in the private fund industry. Although these new requirements may add compliance burdens, especially for smaller funds and emerging managers, these reforms should benefit investors overall. In addition, while this may pose some intellectual property creep, it will be hard to completely parse out manager-specific competitive advantages from this enhanced reporting.
Specific to hedge funds, this does create one key consideration: these additional burdens will most likely lead to additional managers who may have been inclined to launch their own firm instead of continuing the trend of moving to a multi-manager platform. This would be especially true given the inability to allow better fees or liquidity schedules for earlier/larger investments, as it will be harder to find anchor/seed investors that would backstop and fund the enterprise as it grows and builds a track record. This practice is done to compensate early investors for the risks of going in on an untested strategy or if the firm falters and does not reach breakeven size.
While top-tier multi-manager platforms have provided robust long-term alpha, we have seen some detriments to investors, namely limited capacity and onerous fee/liquidity terms given the strong demand for these products. According to data from Goldman Sachs, asset growth in multi-manager platforms has more than doubled since 2017 while the rest of the industry has grown less than 15%. While these managers only hold roughly 10%of total hedge fund assets across strategies, it is estimated they hold close to 30% of total gross market value in US equities, representing a key de-grossing risk during periods of market stress. This was evident in July where multi-manager platforms represented an outsized portion of short covering in crowded technology names that sharply outperformed.
Main contributors - Jennifer Liu, Sean Sanborn, Daniel J. Scansaroli
Original report - SEC Adopts Private Fund Adviser Reforms, 5 September 2023.