SEC’s AMAC urges opening of private funds to retail investors

In a unanimous September 27 vote, members of the Securities and Exchange Commission’s Asset Management Advisory Committee approved a suite of recommendations that would help open up the private funds market to retail investors.

The recommendations are nonbinding, but nonetheless demonstrate continued momentum for the idea of “democratizing” the industry, even as SEC chair Gary Gensler has signaled he may take a tougher approach to regulation of it than his predecessor, Jay Clayton.

AMAC’s recommendations include:

• Expand the pool of private funds open to retail investors. Start by scrapping rules that keep retail retirement funds out of closed-end vehicles with 15 percent or more assets tied up in private equity, hedge or venture capital funds, the committee says.
• Impose “design limits” to protect against risk. That includes requiring “chaperoned access” of retail investors and uniform disclosure rules for such terms as “risk,” “fees” and “returns.”
• Model disclosure and registration requirements on rules in the Investment Company Act. Consider requiring registered investment advisers or broker-dealers to shepherd deals, as well as those uniform disclosure rules, the committee says.

Arm me with harmony

Advocates of “harmonization” have argued for years that closed-end funds were ideal to bring retail investors into private funds. Because they don’t offer daily redemptions, proponents said, closed-end funds offered bigger holdings in longer-term funds, which in turn meant less risk in managing liquidity and valuation.

As late as last summer, then-Division of Investment Management director Dalia Blass said regulators were considering just such a move, but the clock ran out on Blass’s regime.

Some harmonization advocates nevertheless encouraged the new SEC leadership to give the matter the attention it deserved. “I hope,” commissioner Hester Peirce said ahead of the committee’s vote, “remedying the diminishing retail investor options in these markets will be added to the Commission’s admittedly expansive agenda.”

Two chaperones

The committee recommends two routes to protect retail investors coming into private funds.

In the first, the SEC could require any private funds open to retail investors are managed by an independent investment adviser who (and whose affiliates) don’t receive fees or any other income from the investments and who either comply with Reg BI (for broker-dealers) or are fiduciaries (if IAs). That route might add an additional layer of fees, the committee says, so “a careful balance will need to be struck.”

In the second, any private funds offered to ordinary people should have skin in the game, the committee says. Funds should only be open to retail investors if they have “material participation in the fund or investment from more sophisticated institutional investors on substantially the same terms on the basis that such institutional investors would have carefully considered the risk and potential returns of the investment and the appropriateness of the fees being charged,” the committee says.

Diversification

In lieu of the 15 percent cap on closed-end funds, the committee recommends that ordinary investors be given the option of either a “portfolio of separate investments in different private funds” or an “investment in a fund that holds a reasonably diversified mix of private investments.”

“AMAC believes that the SEC should encourage retail investors to hold a diversified pool of private investments within their overall portfolio which should also comprise more liquid investments,” the committee says. “We acknowledge that it may be beyond the SEC’s ability to mandate overall portfolio diversification. There are situations, such as under Regulation Crowdfunding and Regulation A, where the SEC does mandate the maximum investment in a particular issuance based on a non-Accredited Investor’s annual income or net worth.”

‘The RIC framework’

The rules governing registered investment companies are a good place to start, the committee argues, because they require retail investors to work with either an IA with a fiduciary duty or a broker-dealer with a best interest standard, the committee says.

Also, the RIC rules require “standardized disclosure of key items such as fees, risks… and returns,” the committee says.

The Commission may still decide on “some specific modifications” of the “RIC framework,” but it’s at least a start, the committee says.