Funds and their advocates are marshaling their forces to get the SEC to rethink sweeping new audit rules that critics say may deal a crushing blow to America’s flourishing private markets.

Combined with the commission’s Form PF proposals, the would-be audit rules are set to be the most radical changes to the way private fund advisers are regulated since the Dodd-Frank era began. Among other things, the proposed rules would require registered private fund advisers to audit their funds yearly and at liquidation, using a PCAOB-registered-and-inspected accountant acting under US Generally Accepted ­Accounting Principles (GAAP), to send out quarterly statements on fees, expenses, salaries and the like to investors, and to obtain a “fairness opinion” on adviser-led secondaries deals.

The proposals go even further. All private fund advisers, registered or not, would be forbidden from charging accelerated monitoring fees, passing along exam or enforcement expenses to investors, seeking reimbursement or indemnification from exams, enforcement or lawsuits, offsetting taxes by reducing clawbacks, charging portfolio investment fees or expenses unless they’re pro rata, and borrowing from or opening credit lines with private fund clients. It would ban preferential treatment in redemptions or sharing “information about portfolio holdings.” It would require all funds to document their annual audits in writing.

‘Breakneck pace’

Regulators acknowledge that all this will cost fund managers if the rules are adopted. But the SEC’s Gary Gensler and his allies say they have no other choice. The private funds industry, they say, now manages some $18 trillion in gross assets. It’s simply too big to fail.

“It matters because these funds are large and growing larger,” Gensler said at the February 9 commission meeting where the rules were proposed. “Thus, it’s worth asking whether we can increase efficiency, transparency and competition in this field.”

Under public pressure, Gensler reopened the comment period on the ­proposed audit rule. That reopened door shut again on June 13.

“It’s worth asking whether we can increase efficiency, transparency and competition in this field”

Gary Gensler

As you might expect, industry hates the proposals. Advisers and their allies lined up to warn the commission that the proposed rules would be a disaster for private markets and their investors. Opponents have mostly echoed Republican commissioner Hester Peirce’s condemnation of the proposals as “a meaningful recasting of the SEC’s mission.”

Critics of the rule proposals argue they infantilize accredited investors and will divert regulators’ time, money and attention to private fund investors when retail investors need the SEC the most. Peirce has also contended the proposals are “another step toward erasing any distinction afforded by the exemption from registration.”

Peirce is one of several who see Gensler’s proposals as a kind of Trojan Horse that hides his true ambitions: to redefine, permanently, the meaning of accredited investors. Typical was a letter from Rebekah Goshorn ­Jurata, general counsel at the American ­Investment Council.

“Simply,” she says, “the commission is proceeding too quickly, allowing neither the public nor commission staff the time needed to develop thoughtful, properly-tailored proposed rules. This truncated process, exacerbated by the huge volume of commission proposals, risks leading to final rules that are not fully informed by the data and insights available from market participants who must live under the rules. Misunderstandings, errors of judgment and far-reaching unintended consequences are the inevitable result of such a breakneck pace.”

The SEC should scrap the rulemaking altogether, Jurata says. Barring that, “the commission should conduct a far more inclusive, deliberative process than used for the initial proposed rule,” she says.

‘Disproportionate hardships’

Not all critics take that line. Dave Doherty is the general counsel at Chicago-based LaSalle Investment Management ($71 billion in AUM). He says he is worried that the proposal’s auditor independence mandates and its refusal to allow private funds to pay for surprise mock Custody Rule exams in lieu of audits “creates disproportionate hardships for large investment advisers.”

Most funds, some 90 percent, already do audits, regulators say in the rulemaking notice.

Doherty says he is worried that the proposed rules, if adopted, will drive up costs for every company – private funds or not – who rely on a small pool of auditors to help them. The proposed rules could sap companies’ “pricing power in the contract engagement process,” Doherty says.

“The commission is proceeding too quickly, allowing neither the public nor commission
staff the time needed to develop thoughtful, properly-tailored proposed rules”

Rebekah Goshorn Jurata
American Investment Council

“LaSalle and other similarly situated investment adviser firms would also be limited in their ability to negotiate competitive pricing for the sponsored fund’s audit work or to move away from a public accountant if the services rendered are unsatisfactory, given the limited number of firms that could qualify as independent,” he says.

The idea that there are “a multitude of public accountants from which to choose… is misguided on multiple levels,” Doherty adds. “First, sophisticated investors in LaSalle’s pooled funds generally have the expectation that the pooled fund will be audited by one of the ‘Big Four’ public accountants, particularly with respect to funds that specialize in alternative strategies such as real estate.

“Second, public accountants may decline the request to act as an independent PCAOB auditor if that determination could jeopardize or limit their ability to continue to perform (or perform in the future) services for LaSalle’s affiliates.”

Most critics say the proposed rules could have unintended consequences for private fund managers.

Steven Yadegari, CEO of consulting firm FiSolve, says the proposal may restrict an investor’s ability to negotiate better deals on behalf of their beneficiaries, preventing them from investing in a private fund. Side letter terms such as providing advisory board seats, meeting certain statutory requirements or agreeing to regulatory undertakings would not be allowed under the proposal.

Private managers may simply choose not to make side letters available in future funds, which would also keep some investors out of private funds, Yadegari says.

“As proposed, the facts and circumstances standard for determining material, negative impacts for preferential redemption rights or transparency may impede LPs’ ability to negotiate for side letters,” he says. “Managers are likely to take a conservative view on what the SEC may deem material, negative impacts. Consequently, they may resist making side letters available in future funds.”

Yadegari adds: “It will add costs to funds, which will raise the already costly bar for launching a new fund and limit new entrants into the market. Existing managers likely will shift costs to all investors in the form of higher fees.”

In their comments, the US’s four largest audit firms – Deloitte, EY, PwC and KPMG – urge regulators to “clarify” the scale and scope of the proposed audit rules – especially on the ways in which they interact with the commission’s Custody Rule. (The Custody Rule requires registered fund advisers to conduct either a yearly audit or a surprise exam from third-party vendors. It is nowhere near as prescriptive about auditing standards as the new audit rule proposals are.)


“It will add costs to funds, which will raise the already costly bar for launching a new fund and limit new entrants into the market”

Steven Yadegari

None of the Big Four condemn the proposal outright, but PwC says it is worried that the independence rules “will be disruptive to certain audit firms eligible to serve in a relationship with private funds (and result in a decrease in the number of audit firms eligible to serve as an independent audit firm).”

LPs not all on board

Gensler and his allies say they’re doing all this because LPs demand it. Judging by the comments on the audit proposals, they are mostly right about that. Big pension funds from CalPERS to Illinois Treasurer Michael Frerichs have endorsed Gensler’s efforts. Some have even called for the chairman to go further.

“Without clear and consistent disclosures,” CalPERs CEO Marcie Frost says in an open letter to the commission, “the tracking of fees and expenses charged in a private fund is exceedingly challenging. Investor access to basic transparency is therefore the product of market dynamics, disproportionately limiting smaller investors’ access to this information.”

Mostly right. Among those who say they’re worried about the proposals are Samuel N Gallo, the chief investment officer at the $2.1 billion University System of Maryland Foundation. “In particular,” Gallo says in his June 13 letter, “it is important to explore what negative impact certain prohibitions in the proposal would ultimately have on institutional investors by limiting access and raising fees.”

Across the continent, Alaska Permanent Fund Corporation chief investment officer Marcus Frampton echoes Gallo’s worries. The “enhanced disclosures” in the rule proposal should be enough to protect investors, Frampton says. Banning fees and expenses makes him queasy. “We believe the proposal has the ability to increase, rather than decrease, our fees and expenses,” he says. “We also worry it will dramatically reduce our investing opportunities and limit our ability to deliver returns to our beneficiaries.”

New York City Comptroller Brad Lander says his agency supports the rule proposal broadly but has questions about the ban on preferential treatment. He urges the commission to tweak the rules to address “(a) the lack of sufficient guidance on the potential impact on existing fund documents; (b) the unique liquidity needs of government pension plans related to their legal, regulatory and/or policy requirements; (c) the inadequacy of information and redemption rights under hedge fund documentation; and (d) the different information needs of investors that act as members of a limited partner advisory committee… of a fund, given that members of an LPAC typically exercise governance and oversight functions on behalf of all investors in the fund.”

“We believe the proposal has the ability to increase, rather than decrease, our fees and expenses”

Marcus Frampton
Alaska Permanent Fund Corporation

As written, the proposed rules would nuke existing fee and expense agreements. If that kind of language makes it to final rules, it could open the regulations to a constitutional challenge. Article I, Sec. 9 of the Constitution prohibits the government
from enacting ex post facto laws. A regulation that blows up longstanding deals might answer that description, more than one industry advocate

Already cracking down

Whatever happens to the Audit Rule, regulators are already using existing SEC rules to punish funds for lax audit standards. For months, examiners have been asking funds to explain how they’re complying with the commission’s Custody Rule. The questions are many. They are deep, and often go back years.

Enforcement cases are now trickling out from those exams. In March, for instance, Stamford, Connecticut-based private equity adviser Spruce Investment Advisors ($182 million in AUM) agreed to accept censure and to write a $75,000 check to settle commission claims that it failed to send out audited financial statements to its LPs.

From the beginning of fiscal 2015 until the end of fiscal 2020, the SEC brought 14 cases against private funds alleging improper fees, expenses or valuations. Since fiscal 2021, it has brought six such cases – five of them in 2022 alone.

Choosing the right auditor

With the regulatory scrutiny on private fund auditors, and some of the largest audit firms staying away from private fund audits, the onus falls on managers to choose the right audit partner.

There is a concern that some small and mid-size audit firms are giving bad advice to private funds about how to complete their audits and what they should be looking for, simply because they do not fully understand the private fund business. Some point to last year, when the SEC issued two guidance letters about SPAC accounting.

One was a warning about the ­legal hazards of the private-to-public road that SPACs take. The other was a reminder to firms that regulators expect them to uphold accounting standards already on the books.

It sent dozens of SPACs back to the drawing board for their audited financial statements. At the time, their ­accountants spun it publicly as a “new” guidance.

Ann Gittleman, managing director in Kroll’s expert services practice, says the rule proposal underlines the importance of choosing the right

“If the auditor doesn’t understand the type of entity they are auditing, the audit may fail. If the auditor doesn’t understand the client, the auditor may not be able to assess areas of risk. If an auditor does not identify areas of risk, it may not appropriately test the financial statements,” she says.

Gittleman says that under generally accepted auditing standards (GAAS), an auditor plans the audit by assessing the company’s risk areas and then plans their procedures in accordance with the identified risks.

“If there are no controls, and there is one person in control at the company, the auditor will have to increase its testing in all areas of the financial statements, such as accounts receivable,” she adds.

Jonathan Wowak, chief operating officer at Cipperman Compliance Services, agrees that experience with the types of funds they will be auditing is a necessity for audit firms, but stresses that auditor independence is another critical factor in choosing the right firm to review your financials.

Auditors are required to be independent to ensure they give a thorough and unbiased review of accounting and financial reporting.

“Some of the big audit firms, who offer other services, may have a pre-­existing relationship with a private equity manager because they acted as a consultant on some of the manager’s deals,” Wowak explains. “Those relationships can threaten auditor ­independence and call into question the results of the audit.”