The SEC’s Private Fund Adviser Rules represents a sea change in how the regulator treats the industry

For over a decade, regulatory complexity has helped shape how private equity firms build and manage their operations. Outsourcing has boomed, as GPs see the value in offloading the regulatory burden and they’ve institutionalized processes and roles to cast their behavior as rigorous and reliable. But despite all that effort, the SEC has seen fit to further enhance its oversight, with an even stricter regime.

The Private Fund Adviser Rules were finalized in August of this year and will be phased in over the next 12-18 months. Some of the rules impact both registered and unregistered advisers, such as new disclosure rules and some outright prohibitions of preferential treatment for any one LP. And for registered advisers, there are major new changes around quarterly reports, adviser-led secondaries and annual audits.

All these changes guarantee one thing: a windfall of work for GPs, their operational staff, law firms and service providers. GPs would do well to start preparing for compliance now, consulting with their legal counsel and peers, given that the SEC has offered little guidance, so developing a consistent market practice through trade associations and less formal collaboration will be invaluable.

Furthermore, these new rules, by and large, aren’t likely to be relaxed. There have been some legal actions filed against the reforms, but none of the lawyers that Private Funds CFO spoke to for this story expressed a belief that any GP should count on the courts to rescue them. And these reforms are no mere tweaks of existing laws.

Enforced equality

“A sponsor or management company cannot provide liquidity or grant redemption rights to one LP unless they offer it to all LPs,” says Marc Ponchione, a partner at Debevoise & Plimpton. “And they cannot let any LP have access to information [relating to portfolio investments of the fund in question] that is not also shared with the rest of the LPs. Now, these prohibitions contain certain limited exceptions, but the onus is on the sponsor to demonstrate that they apply and they will be subject to second-guessing by the SEC.”

“Some LPs might take a look at the side letters and decide to reopen negotiations,” says Brad Caswell, a partner and head of the US Financial Regulation Group at Linklaters. “And think of the technical aspect of sharing side letters. Do they summarize and risk losing a detail? How do they package those side letters? It’s a huge undertaking.”

Caswell notes one of the major issues with these rules around preferential treatment matters is that it puts the onus on managers to decide what preferential liquidity and transparency terms might have a material negative effect on the rest of the LPs.

“Are certain preferential terms prohibited? Or are they material that need to be disclosed in advance? Or others that can be disclosed after the fact?” says Caswell. “Managers should expect that the SEC will be vetting their decisions around this during an exam, even if they don’t offer much guidance at the moment.”

For registered advisers there are three other areas that will materially impact operations. First, there are new requirements around adviser-led secondaries. “It’s been market practice to do fairness opinions. Now it’s a requirement to do either a fairness or valuation opinion and distribute it to LPs prior to the election date,” says Caswell. “And GPs are required to disclose any material business relationships with the entity performing the opinion within the previous two years.” Like so many of these rules, it codifies certain behavior managers may already do.

Second, registered advisers will have to perform an annual compliance review and provide a written report. “Most investment advisers already put the annual compliance review in writing, but now that report has that the written annual review is required, managers can expect the SEC to test and scrutinize the annual review reports even more closely,” says Caswell. But the third area of note is perhaps the most burdensome to managers.

Supersized reporting

“All registered advisers will now have to provide their LPs a quarterly fee, expense and performance statement, where fees and expenses are detailed and divided up by category, and they can’t be lumped into a ‘miscellaneous’ bucket,” says Ponchione. “This has to be done by fund and by portfolio company, and the performance details required are incredibly granular, such as gross and net of subscription line financing.”

These quarterly reports might be only 10 pages for a new manager, or hundreds of pages for an established one, and must be produced every single quarter. “These rules create major new work streams for managers, so they’ll need to allocate resources to comply. Inadequate resources simply won’t be an excuse to the SEC for not complying with the new rules,” says Caswell.

This burden will change how much GPs need their service providers, from law firms to administrators, and will impact their overall budgets. “All these new requirements will prompt sponsors to add additional staff, even smaller firms,” says Jessica Marlin, a partner with Ropes & Gray. “And when coupled with an already onerous SEC registration process, it might cause folks to reconsider if they want to launch a new PE sponsor at all.”

One of the rare bits of good news is that the SEC seems quite open to allowing managers to allocate compliance costs to the fund. “Interestingly enough, the SEC is not making it harder to offload those expenses to investors,” says Caswell. “In fact, the SEC acknowledges in the final rule they did not want to disincentivize managers from incurring regulatory compliance expenses because that’s valuable for investors. So as long as a manager discloses the costs to LPs, they’ll be able to bill compliance expenses to the funds.”

Still, the scale of the new workload can’t be underestimated. “These rules will demand that the private equity firms invest more in their operational infrastructure to handle these types of issues,” says Marlin. And market observers argue that will likely be a mix of outside providers and new hires.

But lawyers agree that the first step managers should pursue is a scoping exercise, where a manager collaborates with outside counsel to determine which rules apply to them, and if there are exemptions. “The SEC acknowledges that these new rules are not applicable to non-US advisers with respect to non-US funds,” says Caswell. “So there are exemptions, but if a manager has a large complex global structure with an office in the US, the manager could be pulled back in and the scoping exercise is especially crucial, but every manager should start by determining what these rules mean for them, and what it will take to comply.”

Complicating that effort is the lack of guidance from the SEC, which will eventually arrive in the form of exams, when it’s essentially too late. “Due to ambiguities in the rules and release, we suggest managers work with industry peers and trade organizations to understand how the market is interpreting certain issues,” says Christine Lombardo, a partner with Morgan Lewis. “That doesn’t necessarily mean that consensus is how a particular manager will interpret or apply the rules to its business, but there’s some value in understanding how the industry is interpreting issues. This helps to ensure no one is an island out there by themselves, because it is unlikely the SEC staff will give guidance and waiting for clarification isn’t an option.”

Now, not later

One universal bit of advice to managers appears to be, “Don’t wait,” or not to underestimate the workload involved. “Some managers are looking at the compliance dates and thinking they’re 12 months or 18 months from now,” says Christine Schleppegrell, a partner with Morgan Lewis. “But some of these rules are already changing managers’ day-to- day operations. For example, the side letter negotiations are informed by the new regulations, so it’s vital to consider the impact on investor relations and ongoing fundraises.”

And once again, it comes down to the workload on the way. “It’s true that registered advisers won’t need to start producing quarterly reports until March of 2025, but to deliver those properly, they’ll need the infrastructure built and the information gathered by January 1,” says Schleppegrell. “So, the best plans will work back from the date of compliance.”

In short, the compliance dates might be a year or more away, but managers don’t have the luxury of dawdling. These changes will no doubt reverberate for years to come, but the countdown has already begun, and the managers would do well to make this a priority so it doesn’t become an emergency.

The end of the disclosure era

The transition from disclosure to regulation and prohibition in handling conflicts of interest and LP treatments

“Historically, until these rules, GPs and sponsors were subject to a disclosure-based regime to deal with conflicts of interest or preferential treatment for some LPs,” says Marc Ponchione, a partner at Debevoise & Plimpton. “By law, LPs are required to be sophisticated, and GPs were required to disclose material facts and conflicts, and specific deal terms were handled as part of a bilateral negotiation between sophisticated parties, a practice blessed by the SEC as recently as 2019. Now, the new rules impose prohibitions on actual, specific conduct and certain terms practices are prohibited, or at minimum highly regulated.”

Ponchione explains that in many ways, the SEC took the regime that governed retail fund investing and effectively applied it to private funds, which is arguably contrary to Congress’s intent in designing the federal securities laws to apply very differently to those two types of investments.

However, some of the new rules from this regime only apply to registered investment advisers, while others govern all. The two key areas that apply to everyone in the industry are restricted activities and the preferential treatment of LPs. The list of new rules in both categories runs long, which is why relying on legal counsel is crucial.

From a bird’s eye view, the restricted activities largely center around how to handle fees and expense allocations. Allocations that once only needed to be disclosed to LPs now require their consent and at times, are outright prohibited. “In most cases, GPs can’t borrow from the fund without investor consent,” says Stephen Mears, a partner in Proskauer’s Private Funds Group. “In addition, GPs can’t charge the fund for costs related to investigations of the GP, without consent. But what GP wants to call up their LPs and announce they’re under investigation and now need to charge the fund? So, in practice, it may turn out to be more of a prohibition.”

The other area that applies to all managers concerns preferential treatment of LPs, which once again, used to be addressed by a broad disclosure, but now includes hefty new requirements and actual prohibitions. “The new rules around the preferential treatment of LPs are centered around preferential liquidity and information rights as well as material economic terms,” says Brad Caswell, a partner and head of the US Financial Regulation Group at Linklaters.