The SEC’s new marketing rule has come into force just as private funds find themselves in a cash crunch, and some compliance experts are worried it’s created a toxic mix for the industry, reports affiliate title Regulatory Compliance Watch.
“If your firm is having trouble raising capital, then marketing becomes a bigger regulatory risk,” said Igor Rozenblit, founder of compliance firm Iron Road Partners. “Valuations drive performance, which is a key component of marketing. It’s a witches’ brew, which deserves attention.”
Valuations have long been fraught terrain for private fund advisers. More than one out of every five SEC enforcement case filed in the Dodd-Frank era has involved valuations, fees or expenses (RCW, October 28, 2022). “But with the implementation of the new marketing rule, the Commission has new tools to scrutinize advertisements,” Rozenblit said. “This, combined with an ongoing marketing sweep could create a potentially hairy situation for investment managers.”
The new marketing rule is broadly written. It will be strictly enforced. Private funds have struggled and are struggling with proper calculations – and proper methods and written policies and procedures – for extracted, net and gross performances (RCW, January 26, 2023), Even before the new rules took effect, private fund advisers sometimes found themselves in trouble when regulators checked firms’ public statements against firms’ valuations (RCW, March 11, 2022).
‘Process is punishment’
With world markets wobbling, private funds’ valuation problems may get worse before they get better. Last year, the dreaded denominator effect reared its ugly head. Shrinking public portfolios left many institutional investors overallocated to private equity. That’s particularly vexing for the likes of US pension funds, which operate under or within strict allocation targets or ranges.
This, in turn, has led some investors to make difficult decisions such as reducing commitment sizes to private funds, or declining to re-up with some of their fund managers. After setting a record for cash raised in 2021, private fundraising fell by more than $100 billion last year, affiliate title Private Equity International reports. The number of funds closed fell by a third, to 1,520 – the lowest since 2016, PEI found.
The industry’s cash crunch has brought new regulatory attention to a sector that had already spent the previous two years learning the hard way why some nod wisely whenever they hear the old saw, “The process is the punishment.” Last fall, managers at giant private fund advisers Blackstone, KKR and Starwood all announced limits on redemptions in some of their real estate funds (RCW, January 30, 2023). Regulators have already opened investigations.
The process will grind on. When the SEC released its exam priorities last month, private funds were near the top – right behind a promise to sweep the entire advisory industry for compliance with the newly adopted marketing, derivatives and fair valuation rules. Regulators plan to examine private fund advisers for, among other things, how they’re calculating fees and expenses and complying with the marketing rule.
They’ll also pay close attention to private funds with “specific risk characteristics,” including those that “hold certain hard-to-value investments, such as crypto assets and real estate-connected investments,” and funds “involved in adviser-led restructurings, including stapled secondary transactions and continuation funds,” regulators said (RCW, February 13, 2023).
“Compliance and marketing teams are in a challenging spot,” said Adam Aderton, former co-head of the Commission’s Asset Management Unit, now a partner with Willkie Farr & Gallagher. “The performance reporting requirements in the marketing rule are a big deal. There is the obvious business desire to report higher performance to support fundraising and other objectives. At the same time, marketing rule performance reporting is a top exam priority. Private fund advisers will need to be deliberate and thoughtful about their performance reporting process and disclosures to avoid inadvertently running afoul of the marketing rule.”
‘Pressure from all sides’
“I would just overlay on top of that,” Aderton added, “the economic reality that both business professionals and limited partners in private funds get their carry and returns through exits. You are not seeing a lot of exits right now. One possible solution is through continuation funds. The SEC seems to have recognized this and said, ‘We’d like a closer look at those funds.’ The SEC’s approach could make advisers feel like it is coming from all sides.”
Greg Larkin, a partner at Goodwin, Procter, has spent much of the past two years warning private fund industry about the marketing rule (RCW, October 28, 2022). He said the exam priorities haven’t calmed any of his nerves there. They have made him more nervous about fees and valuations, though.
“People who base their fees off the value of the investments – particularly, for commercial real estate firms, but also venture capital firms – they’ll have to be very careful they’re following their own policies and procedures,” Larkin told RCW. “If you sponsor any of those kinds of funds, the SEC is going to ask, ‘How stable are those valuations? How quickly are you making the adjustments or writing them down? How faithfully are you following your disclosures and policies?’
“People who base their fees off the value of the investments – think not just of the commercial real estate firms, but also venture capital firms – they’ll have to be very careful they’re following their own policies and procedures,” Larkin told RCW. “If you have any kind of investment in any of those kinds of funds, the SEC is going to ask, ‘How stable are those valuations? How quickly are you making the adjustments?’”
So how can compliance officers fight the multifront battles to stay on the right side of the marketing rule and potential valuation/fee problems? Here are some of our experts’ tips:
- Consider extra disclosures. “On the marketing rule, because there’s more stress on the valuations’ disclosures, ask yourself if there are more disclosures you should be making around your methodologies and assumptions,” Goodwin’s Larkin said.
- Push your teams for up-to-the-minute information – and use it. “You can’t necessarily rush out your valuations if you don’t have solid fourth quarter numbers yet,” Larkin said. “But as soon as you have your fourth quarter numbers, you should be using those fourth quarter numbers.”
- Focus on your valuation models, not your valuation process. This can be a bind spot especially for mid-sized private fund advisers, Iron Road’s Rozenblit said, “where the same people often create the model, make the assumptions and approve the models in valuation committee.”
- Don’t ignore process, either. Willkie Farr’s Aderton said a “robust valuation committee process” or limited partner agreement may not get you the “right” valuation, “but you’ll have a defensible process to show a good faith effort to comply with the marketing rule.”
- Check yourself. “You should expect that examiners will test any valuations they deem as high risk,” Rozenblit said, “so conducting similar testing is the best way to stay ahead of any issues.”