On the face of it, the enhanced disclosure and transparency rules finalized by the SEC last month would appear to be a boon for limited partners.
They prescribe things such as: quarterly reporting on fees, performance and expenses; disclosure of “preferential treatment” of certain investors and equal information sharing with all LPs in a fund; annual audits of each fund; even LP consent to charge a fund for investigations or examinations.
But depending on who you ask, portions of the rules will make life easier… for GPs.
Quietly, several sources have told me they see the rules as providing GPs with an advantage, especially when it comes to providing the same level of information access to all investors in a fund.
As well, the idea of any sort of regulation of side letters, which have proliferated over the years to become something of a burden to managers, is a welcome step for GPs. With the new rules, side letter arrangements are not banned, but side deals need to be disclosed to all LPs, making it easier for managers to streamline the terms of funds.
Larger LPs with more sway based on the size of their commitments have traditionally been granted more information access by GPs. This includes more access to certain information about portfolio companies, fund exposures or even co-investment opportunities.
The SEC’s rules attempt to level the field – forcing GPs to mostly provide the same level of information access to every LP in a fund. Information asymmetry can still exist among LPs in a fund, as long as the GP is reasonably sure the information mismatch will not negatively impact one LP over another.
The risk is a dumbing down of the kind of info GPs make available on an official basis to every LP, with the caveat that, for those who want more detail, they need to make an in-person visit to examine the information “off the books”, an attorney that works with LPs told me recently.
Sharing basic information
Add to this that, according to the new rules, GPs can’t charge the fund for investigations or examinations (without LP consent). A GP is going to do everything possible to avoid paying out of pocket if they get hit with a disclosure violation, giving them more incentive to share only the most basic of information with all LPs.
“If you’re a GP, are you going to increase transparency across the board? The SEC said give everyone the baseline; if you give more, you have to tell everyone. If you’re the GP, what are you going to do?” an attorney who works with institutional investors told me.
“Big, sophisticated LPs can say, ‘I can still get my competitive advantage, I just have to work a bit more’,” the attorney said.
However, another source pushed back on this idea, pointing out that the information asymmetry risk is more relevant for hedge funds and managers trading in semi-liquid or liquid securities, rather than long-holding private equity.
A negative impact on information sharing is more likely for two investors in a hedge fund: one investor gets negative information about an investment, while the other does not. The first investor might use that info to make a redemption request, absorbing the liquidity in the market for the security, leaving the second investor holding the loss.
“In private equity, if I tell you about a company that I don’t tell someone else in the fund, that’s not really going to hurt the other person. In private equity, it’s tough to find the kind of information that would trigger that at all,” a consultant told me.
The closest private equity gets to the idea of information asymmetry negatively impacting other LPs is potentially with secondary deals, but even then it’s not clear.
If a company that is targeted for a secondaries experiences a major loss, which would impact its valuation and perhaps the price of the secondary, the GP is at risk for bigger issues than violating the SEC rules if it withholds that info from some LPs, the consultant said.
Opinions vary, and the real-world impacts of the rules are uncertain. Lawyers are up in arms, GPs are worried and dreaming of money flowing out of firms like a homeowner with a plumbing issue.
The industry is not holding back. A collection of industry groups filed in federal court to block the rules. We’ll see how it plays out in court and meanwhile, as the industry wallows in the worst fundraising environment since the GFC, we’ll see the everyday impacts of the rules in real time as (most) managers struggle to raise.
What do you think? I’ll be talking to folks over the next few weeks about the rules and how they are shaping negotiations. Reach me if you want to chat at firstname.lastname@example.org or find me on LinkedIn.