SEC’s private funds overhaul effort enters most important stage

The next few months could represent the most impactful period of regulation in Dodd-Frank era for the $25 trillion private funds industry.

There are nearly two-dozen epoch-making rule proposals pending, and it all kicks off with a vote on the megaton private funds compliance rule on Wednesday.

“The private funds compliance rule is coming next week, there’s no mystery about that,” Akin partner Brian Daly tells Private Funds CFO. “I would think at this point, the Enforcement Division is doing its usual year-end wrap-up for matters in or entering a resolution stage. We’ve also just entered the comment period for the ‘predictive data analytics’ proposal.  So, overall, we’re hunkering down for a busy next 15, 16 month period — at least until there’s a new president sworn in.”

Now or never

The next few months are also critical to fulfilling the promise SEC chairman Gary Gensler made to overhaul the private funds industry.

It’s been decades since a chairperson served beyond a single presidential term. Any final rules adopted beyond spring next year could fall victim to the Congressional Review Act or become a political issue in next summer’s presidential campaigns — or both. That leaves precious little time left for Gensler to push through his agenda.

“Gensler’s view has been that there is no such thing as a private fund, essentially,” Wilson, Sonsini partner Neel Maitra says. “He’s said it himself — ‘The funds pool the money of other people: the limited partners. And who are those limited partners? Often, they’re retirement plans, like state government pension plans, or non-profit and university endowments. The people behind those funds and endowments often are teachers, firefighters, municipal workers, students, and professors.’”

The difficulty is that because so few ordinary Americans are directly invested in private funds, it means the industry doesn’t have a natural political constituency to protect it, Maitra says. In an increasingly polarized age, it’s common for rules to zig and zag as political fortunes wax and wane. Private funds regulation has been an exception, Maitra says.

“Has the window shifted for how much regulation private funds will have to tolerate? I think yes, absolutely,” he says. “The overall trajectory of private funds hasn’t been two steps forward, one steps back, it’s been 10 steps forward, one step back. The line has continued to advance.”

If even a fraction of the proposed rules are adopted as-is, they could change everything for everyone in the private funds industry, says Managed Funds Association chief counsel Jennifer Han.

“The unprecedented number of rulemakings the SEC has proposed in the last two years with little substantive analysis and absent an aggregate or interconnected cost-benefit analysis threaten investors broadly, including alternative asset managers and their investors,” she says. “In the aggregate, the proposals will raise costs, increase barriers to entry, reduce competition, and limit investment choice for pensions, foundations, and endowments.”

Wobbly economy

The wobbly world economy has strengthened Gensler’s hand.

“This has been one of the strangest times CFOs and CCOs have ever seen,” says Abhishek Pandey, co-founder of software valuations firm 73 Strings. “On one side fund raising has not been as easy, which means there is increasing cost pressure at the same time there is increasing pressure from regulators and auditors to adhere to best practices. There are some operational challenges as well, as typical LBO-type, value-creation processes based on leverage has become completely outdated in the current environment and the focus is moving towards value creation which means access to more and more operational data at higher frequency.”

That, in turn, has given Gensler his entrée, Pandey says. “It was a wake-up call for regulators,” he says. “They could see so many varying practices around marks for the same assets across the industry. The variances have always been there, for good or bad reasons, but the delta went up astronomically. The most affected segment due to this was the venture capital and growth industries. These are sub-sectors where subjectivity is extremely high around how you look at performance of portfolio companies and it resulted in asset allocators becoming more cautious of this sector.”

Enforcement activities

Whatever else happens, Gensler has already shown that he doesn’t need new rules to address private markets. Under his leadership, examiners and enforcers alike have expanded the scope of what’s possible, and even what’s thinkable.

We’ve already seen a handful of valuation cases, and a spike in so-called “gatekeeper” enforcement actions. Examiners have been asking about how funds — especially debt and real estate funds — manage liquidity and risk. They’ve also been asking about whom they’re getting advice from. As FY2023 draws to a close, it’s likely we’ll see some of those questions addressed.

Of course, enforcement actions are useful to regulators in their rulemaking, too. The outsourcing proposal, for instance, didn’t offer any cases to justify regulators’ worries. There have been at least four different gatekeeper cases since March of this year, and they’re likely to be cited in any final outsourcing rules.

For Akin’s Daly, as frenetic as Gensler’s term has been, he’s accelerated trends, not created them.

“The gravitational pull on this is toward a large, integrated financial services model,” he says. “When I started in this business, the hedge fund managers generally were refugees from the large investment banks. And they universally shared a disdain for ‘bureaucracy.’ In 2023 and beyond, the ‘bureaucracy’ of running a private fund is now rivaling that of a pre-Dodd-Frank asset management unit at a global investment bank.”

“Clearly,” Daly adds, “that’s the model of what Washington has bought into. They want to see centers of control — centers of risk control, centers of compliance controls — the SEC wants to have a closer relationship with a smaller number of large, sophisticated advisers, and wants to worry less about a diffuse number of smaller players.”