Eleven pension funds and three trade associations representing pension fund managers have urged federal appellate judges to dismiss a challenge to the SEC’s sweeping new private fund rules – not so much in defense of the rules as in defense of the commission’s right to make such rules.
In an amicus brief filed in the US Court of Appeals for the Fifth Circuit just before Christmas, lawyers for the pension funds and associations say they’re worried that GP advocates are trying to prevent the SEC from regulating private markets altogether.
“Amici do not necessarily agree with every aspect of the private fund adviser rules, but they write to emphasize the structural issues they face, the tangible investor-protection benefits provided by the private fund adviser rules and to confirm that this private fund rulemaking lies precisely within the SEC’s three-pronged statutory mandate that includes investor protection, the maintenance of fair and efficient markets and facilitation of capital formation,” the pension groups and associations say in their brief. “Minimum standards of disclosure are necessary for investors to make informed capital allocation decisions and to perform ongoing monitoring of their investments in private funds, which are typically long-term and illiquid.”
The amicus brief is signed by lawyers for the Institutional Limited Partners Association, the Council of Institutional Investors, the Chartered Alternative Investment Analyst Association and 11 pension funds, ranging from the California State Teachers’ Retirement System to the Missouri Department of Transportation and Highway Patrol Employees’ Retirement System. Pension funds were a core constituency of the broad-based rules adopted by a divided SEC late last summer. Their Dec. 22 amicus brief is hardly a full-throated endorsement of the new rules, but pension fund advocates say they’re worried that an adverse decision would leave pension funds without a referee in a game already riven with “structural” imbalances.
“Due to structural challenges in private markets and the resulting bargaining inefficiencies,” the pension funds and groups say in the amicus brief, “even the largest and most ‘sophisticated’ investors often spend significant resources to attain alignment of interests around key governance and disclosure terms in the contracts that govern the relationship between the fund, the adviser and the investors.”
Private fund managers, the pension funds and groups claim, already “hold outsized control of information and influence over the fund formation process. As a result, despite their sophistication and best efforts, investors often face headwinds in negotiating for common, but critical governance terms, including consents and disclosures.”
Six trade groups representing private fund managers sued to block the new rules within weeks of their adoption. Pension funds and their advocates are worried because they read the litigation as a frontal assault on Sec. 211(h) of the Investment Advisers Act, as amended by Dodd-Frank. Private fund managers say that section should only apply to retail investors. Pension fund managers say that such a reading would cripple the SEC’s authority to enforce already existing rules such as the marketing rule, but also future rules that pension funds – and the millions of ordinary Americans behind them – may need.
“The SEC’s regulatory authority over the private fund industry has shown itself to be an essential addition to the industry since Dodd-Frank Act, passed in 2010,” ILPA senior director Neal Prunier told Private Funds CFO in a Zoom interview. “While support for different elements of the private fund adviser rules may differ, there is full-throated support amongst the LP community for the important role the SEC plays with their mission to protect investors, maintain fair and efficient markets and to facilitate capital formation. Maintaining the SEC’s regulatory authority is critical for LPs given the SEC’s ability to review conflicts across a GP organization and ensuring better disclosures to offset the structural challenges within the industry that impact even the most sophisticated of LPs.”
Floor or ceiling?
Pension funds are trying to strike a delicate balance along multiple axes, says Chris Hayes, a former top ILPA lobbyist who now advises financial services firms as a managing partner of Washington-based consulting firm Capitol Asset Strategies.
“LPs have had concerns around conflicts, fiduciary duty, fee transparency,” he says. “The private fund adviser rules offer solutions to LPs for some of those issues, but those solutions come with downsides – including a lot of additional costs and uncertainty in LP/GP negotiations.”
LPs don’t want the private market to become just another version of mutual funds, where pension fiduciaries select from a narrow menu of off-the-shelf products, but they do want minimum standards of disclosure, openness and conflict-mitigation, Hayes says. The problem is that SEC chairman Gary Gensler “threw in much more than the kitchen sink” in the final private funds rules.
“What LPs want will likely diverge depending on their size, scope and relative position in the market,” Hayes says. “Larger pension funds especially are likely to be much more confident in their ability to negotiate bespoke side letter terms than smaller ones.”
The question is whether regulators should set a floor, or a ceiling, Hayes says.
“LP solidarity only goes so far,” he says. “They are after all competitors for allocation. That’s certainly part of the challenge in this case.”
‘Save our side letters’
Indeed, Gensler and his team were caught off-guard by the tepidness of LPs’ response to the rules when they were first proposed in early 2022. Gensler made one of his first public speeches as chairman at ILPA, where he promised them that GPs would no longer be allowed to outsource their fiduciary duties.
ILPA and other pension fund advocates balked at some of the side letter provisions in the rules. The initial rule proposal called for many “preferential treatment” terms in side letters to be banned altogether. ILPA and other pension advocates mounted a “save our side letters” campaign. The final rules softened the proposal – side letter terms are no longer banned but many must now be disclosed to all investors and some must be disclosed and agreed to by their investors. Many pension funds are still uncomfortable with that, Hayes says.
“What the SEC did was basically create a bunch more paperwork with some elements of these new rules,” he says. “The question is, what is the utility of all that? You’re going to dump more paperwork on LPs’ desks. That may not really add value.”