For the first time in decades, private funds find themselves at the center of concentrated attention in Washington, DC. Both regulators and lawmakers appear to have concluded that private markets have had their own way for too long, and it’s time to rein them in.
The Securities and Exchange Commission is weighing revisions to Forms D and PF, new disclosures across the financial services industry, a peel-back of the definition of ‘accredited investors’ and new rules for family offices, trusts and foundations.
The commission has also promised to ratchet up exam and enforcement cases, with a special eye on private funds. An exam sweep on SPACs may be in the offing. There are scattered reports that examiners are asking funds to account for more than the usual year or two of records.
Exams, some experts warn, are getting deeper, wider and longer.
Meanwhile, members of Congress are weighing legislation that would impose anti-money laundering rules on private funds.
“It’s a time for change for private funds,” says Igor Rozenblit, a former SEC examiner who now heads his own consulting firm. SEC chairman Gary Gensler “has not been shy in publicly talking about the fact that people in financial services make too much money. Private equity is a pretty high-fee industry, and I’m thinking he means them.”
How did we get here and how do funds manage the increased scrutiny from regulators?
When writing about the transformation in private fund regulation and legislation, the mainstream press often points to Democrats, long considered hostile to private equity, hedge and venture capital funds. It is true to say they are the tip of the spear in Washington’s effort to rein in private funds, but some Republicans are also keen to see the SEC become more assertive.
At Gensler’s confirmation hearing in March, Republican senator John Kennedy asked some pointed questions about the Great Recession. “Why didn’t somebody go to jail? Who made the call?”
(Gensler responded: “Those are questions I share with you, sir.”)
Last year, under Republican chair Jay Clayton, the SEC brought at least 31 separate cases against private funds, nearly twice as many cases brought during 2019.
“Ultimately, every pension fund investing in these private funds would benefit if there were greater transparency and competition in this space”
Much of the attention around private fund reform has focused on Gensler. Some private fund advocates see him as the embodiment of all four horsemen of the apocalypse.
It is true, broadly speaking, that Gensler is aggressive. It is also true that he has surrounded himself with people who have been openly skeptical of the private funds industry.
Finally, it is true that Gensler has earned a reputation as a doer. As head of the Commodities Future Trading Corporation, he implemented all of its Dodd-Frank mandates, something that still eludes the SEC.
However, any fund blaming Gensler for its problems is making a category error. It has taken more than a decade for the SEC to build up its expertise in private funds, and the politics around the industry have shifted at the same time.
If private funds now see themselves being sized up by regulators, it may be an ironic tribute to their success. As Gensler is fond of pointing out, the number of private equity funds has increased by 58 percent over the past five years, while the number of venture capital funds has grown by 110 percent.
In the first two quarters of this year, nearly 5,200 firms registered as private fund advisers under Dodd-Frank, a new record, according to the SEC. Since Obama signed the Jobs Act in 2012, nearly 177,000 have filled out a Form D. In 2019, that market raised $1.5 trillion, SEC data shows. Given the industry’s success, it was inevitable that private markets would draw more attention from regulators and lawmakers.
“The asset management field not only is growing; it is evolving,” Gensler said in a September 29 speech. “SEC staff are seeing new strategies, structures and business practices. Technology is rapidly changing. This trend not only creates new opportunities, but also risks for markets and investors. The SEC must grow and evolve with the industry.”
As they have exploded in number, private funds have attracted some potent enemies along the way. State regulators, for instance, have for years complained about the SEC’s Reg D, which governs private placement exemptions, saying it allows scam artists to set up shop, con locals and fold up the tent before anyone can figure out something is wrong.
Unions, too, have been critical of private funds, pointing to private equity investments that have hurt their members.
Many “private equity and hedge fund managers are engaged in self-dealing and overcharging investors, including pension funds that provide for the retirement security of millions of Americans,” a coalition of advocacy groups and labor unions wrote to Gensler this summer.
“We urge the SEC to swiftly bring enforcement cases against private fund managers who charge improper fees, fail to disclose clear conflicts to their investors, and trade on Material, Nonpublic Information (MNPI) to fulfill its mission of protecting investors.”
Profiting from the financial crisis in 2008 certainly didn’t burnish the image of some private funds. When Americans lost their homes, “private equity funds with access to cheap cash were waiting to scoop them up,” Democratic senator Sherrod Brown claimed this year at an October 21 hearing about private equity.
Friends like these
Erstwhile friends of private funds may have also helped invite new scrutiny. Under Clayton, the SEC expanded the definition of accredited investors and relaxed rules on general solicitation.
Meanwhile, Trump’s Labor Department allowed defined contribution pensions to enable members to invest in private funds. Both of those industry “gifts” prompted criticism.
“It’s a time for change for private funds. [SEC chairman Gary Gensler] has not been shy in publicly talking about the fact that people in financial services make too much money. Private equity is a pretty high-fee industry,
and I’m thinking he means them”
Former SEC examiner
SEC commissioner Allison Herren Lee said in a mid-October speech: “Time and again, we take regulatory action on the grounds that it may encourage companies to go public, but if that is a legitimate goal of the securities laws, then we should also work to ensure that the boundaries between public and private markets are sensibly drawn and maintained, and that the incentives for going public remain balanced.”
Meanwhile, in the decade-plus since Dodd-Frank, regulators have acquired a hard-won expertise in private funds. Now the SEC has its own dedicated team of private funds examiners and advanced analytics to help them monitor the business.
The good news is there are no surprises here. Whatever reforms Gensler gets through as chair in the months and years ahead, the SEC has been telling the industry for a while what it should expect to see.
Last year, under Clayton, the SEC issued its first risk alert dedicated to private funds. It found that advisers struggled with disclosing fees, conflicts of interest and managing the risk of insider information leaking out. In March, the commission laid out its exam priorities, saying it would focus on the findings of the risk alert. They added that they would look at how funds handle advanced data. More than that, regulators said they wanted to see “robust” compliance programs woven into the very fabric of the firms they examined.
Few expect the next few months of exams and enforcement to reveal a radical new course. The only change is the tone and tenor coming out of the SEC. Gensler and his staff have made two things clear. First, that they want more vigorous enforcement of existing rules than previous regimes. Second, they think private funds are a perfect place to test enhanced enforcement.
“There has been such a push under the last administration on retail investment advisers, and Gensler kind of hinted that he’s thinking more about private funds,” says Margaret Nelson, a former SEC enforcement attorney who is now a partner with Foley & Lardner in Chicago.
“You can see in Gensler’s most recent testimony the focus on pensions. There’s an awareness that private funds have mom-and-pop investors behind them, even if indirectly. And it seems like they’re focusing on newly registered IAs, as well as IAs that haven’t been examined in a while.”
Gensler is worried that private funds might be too private. He has used the word “transparency” or variations of it at least four dozen times since his confirmation as chair in March.
Testifying before the Senate Banking Committee in mid-September, Gensler said he had “particular” concerns about private fund advisers’ fees and conflicts.
“I believe we can enhance disclosures in this area, better enabling pensions and others investing in these private funds to get the information they need to make investment decisions,” he said. “Ultimately, every pension fund investing in these private funds would benefit if there were greater transparency and competition in this space.”
The months and years ahead may indeed bring the toughest regulatory climate for private funds since the Great Recession. Fund advisers can call Gensler’s bluff and find out just how “transparent” he’s being, or they can take him at his word and get cracking.
Gensler has laid out the most sweeping private fund reform agenda since the Great Recession.
Promises are a long way from delivery, but it is probably wise to expect SEC chairman Gary Gensler to follow through on his proposals. He has earned a reputation as someone who gets things done – when he ran the Commodities Future Trading Corporation, it implemented its Dodd-Frank mandates, while the SEC has yet to comply. Here are a few areas where Gensler is pushing for reform.
On November 5, the commission adopted new rules on performance-based fees. More than 85 percent of registered private funds charge performance-based fees, SEC records show.
Dodd-Frank requires it. But the SEC warned funds under Republican Jay Clayton last year that their fee disclosures were too opaque. Gensler is on the record saying fees are probably too high, as well.
What’s being considered?
The SEC is adopting amendments to the rule under the Investment Advisers Act of 1940 (“Advisers Act”) that permits investment advisers to charge performance-based compensation to “qualified clients.” The rule defines “qualified client” with reference to specific dollar amount thresholds, which are required to be adjusted every five years to account for the effects of inflation.
The SEC adopted Regulation D in 1982. It exempted funds from having to register with the SEC as long as they do not advertise to the broad public and only accept money from accredited investors. The rules of Reg D eased in 2012, when President Obama signed the Jobs Act, repealing the prohibition against “general solicitation,” or publicly recruiting investors.
According to SEC statistics, more than 177,000 Reg D companies were formed between 2009 and 2019. Private equity got the lion’s share of fundraising, with $11 trillion out of the $15 trillion raised in the decade.
Loose registration requirements mean firms do not have to file a Form D until they make their first sale, and even then, it is not clear how quickly they must do so. Critics, especially state regulators, have argued for years that Reg D allows con artists to set up in a given jurisdiction, fleece investors and then leave the area before regulators know something is wrong.
“If we had filings that come in advance, we’d have an idea of what was going on,” says Melanie Senter Lubin, Maryland’s top securities regulator and president of the North American Securities Administrators Association. “Because they require post-sale filing, we don’t have the opportunity to be the gatekeeper ahead of the deal, and we can’t check deals after they’ve been made.”
What’s being considered?
Gensler has put Reg D reform at the top of his agenda. He has kept things broad so far. His regulatory flexibility agenda says that staff is considering rules that “further update the commission’s rules related to exempt offerings to more effectively promote investor protection, including updating the financial thresholds in the accredited investor definition, ensuring appropriate access to and enhancing the information available regarding Regulation D offerings, and amendments related to the integration framework for registered and exempt offerings.”
State regulators and close advisers to Gensler have argued that he ought to widen the definition of “shareholder of record.” Count individual investors, regardless of whether they’re coming through a blind pool or not, as a shareholder of record, they say, and the commission will automatically pull countless unicorns into the broad light of day. It might also help regulators get closer to determining the beneficial owners behind exempt funds.
Private funds with at least $150 million in assets under management are required to register with the SEC as investment advisers (unless they rely on a Reg D exemption). Like all investment advisers, those firms must file a Form ADV at least once a year, detailing their executives, compensation model and AUM, among other things. Unlike other IAs, private funds must also file a quarterly Form PF. A blank version is 64 pages long. It canvases everything from fund concentration to fund debts. It is supposed to help regulators get a handle on systemic risk to help avoid another financial crisis.
There are nearly as many reform constituencies as there are pages in Form PF. The Institutional Limited Partners Association wants the SEC to require private funds to share their Form PFs with investors. Many regulators say Form PF focuses too much on hedge funds and misses brewing problems in private equity or venture capital funds. Republican commissioner Hester Peirce says the form still does not capture enough data on third-party risks.
What’s being considered?
The SEC chair has been unusually tight-lipped on this one. The regulatory notice merely says the commission is considering “amendments to Form PF, the form on which advisers to private funds report certain information about private funds to the commission.”
Gensler has said more than once that private funds need to be more transparent with their investors.
What’s being considered?
In testimony to the Senate Banking Committee in September, Gensler said he has instructed his staff to come up with new rules for “enhanced disclosures” for hidden fees and conflicts of interest. “Ultimately, every pension fund investing in these private funds would benefit if there were greater transparency and competition in this space,” he said.
An accredited investor is someone who:
1. Earned at least $200,000 in each of the previous two years and reasonably expects to earn that much in the third year. The threshold is $300,000 for a couple; or
2. Has a net worth above $1 million, not including home value, “either alone or together with a spouse or spousal equivalent”; or
3. Holds a general securities, investment adviser or private securities license.
Democratic commissioners say the income/net worth criteria needs to be brought up to date. “We should update the thresholds and index them to inflation going forward,” commissioner Allison Herren Lee said in May. “There is room for debate as to how well financial thresholds operate as a proxy for investment sophistication. But as long as they continue to function as one of the principal investor protections in this market, it is untenable for the commission to fail to update the thresholds to ensure they remain an effective investor protection tool.”
What’s being considered?
Gensler says he wants to update “the financial thresholds” as part of his Reg D reform efforts.
Special purpose acquisition companies have been around since the early 1990s, but they only recently exploded in popularity. Sponsors raise money through the public markets for what is essentially a blank check to be used to buy a company later. Fewer than 100 of these blank check companies went public annually between 2003 and 2019, but 248 SPAC IPOs were completed in 2020 and another 511 made it out in 2021 as of early November, according to the SPAC Data website.
Gensler says there “are a lot of fees and potential conflicts inherent within SPAC structures, and investors should be given clear information so that they can better understand the costs and risks.” Four Democratic senators recently published open letters critical of SPACs. “Between January 19, 2019, and January 22, 2021, the average SPAC sponsor saw returns of 958 percent, [but] the average investor that sold its stock and warrants right before a merger averaged a 40 percent return,” the senators wrote in one of the letters.
What’s being considered?
The SEC chair has asked staff to come up with potential rules for “enhanced disclosures,” particularly around dilution. He also says he would like an “economic analysis to better understand how investors are advantaged or disadvantaged by SPAC transactions.”
The SEC draws most of its authority over private funds from three foundational New Deal-era laws: The 1933 Securities Act, the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940.
The first two acts gave the commission its mission statement: “to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.”
The Advisers Act imposed a fiduciary duty on investment advisers. The Dodd-Frank Act brought private funds of $150 million or more in assets into the Adviser’s Act and its associated rules. That’s a broad writ. It gives the SEC the right to examine nearly any company that deals in securities, or that the commission suspects of dealing in securities. The agency can bring civil enforcement actions on its own authority or make criminal referrals to the Department of Justice.
Most of the SEC’s exams or enforcement activity comes under the volumes of rules adopted under the New Deal acts. Under the Administrative Procedures Act, any new rules require public notice and a public comment period, followed by an open vote among the SEC’s commissioners. Rulemaking can take months, sometimes years.
However, commission leadership can have an outsize, indirect influence on policy through staff guidance and/or exam or enforcement priorities. A seemingly subtle shift in language, or even tone, can mask a multitude of policies that are not on the books. Washington, DC lobbyists call this kind of thing “rulemaking-by-enforcement.”
For example, SEC Enforcement director Gurbi Grewal announced in October his staff would pursue enforcement cases against individual executives. More than that, he made it clear staffers were more likely to pursue individual banishment from the financial services sector than they had been under Republican SEC chair Jay Clayton.
“When it comes to accountability, few things rival the magnitude of wrongdoers admitting that they broke the law, and so, in an era of diminished trust, we will, in appropriate circumstances, be requiring admissions in cases where heightened accountability and acceptance of responsibility are in the public interest,” Grewal said. “Admissions, given their attention-getting nature, also serve as a clarion call to other market participants to stamp out and self-report the misconduct to the extent it is occurring in their firm.”
‘Under the microscope’
“I think there’s an awareness that private funds are going to be more under the microscope,” says Margaret Nelson, a former SEC enforcement attorney who is now a partner at Foley & Lardner.
Rulemaking-by-enforcement can take on a life of its own. For example, before Gensler was even nominated to lead the SEC, the Division of Corporate Finance issued new guidance reminding SPAC organizers that they were bound by a whole suite of disclosure rules from sponsors to underwriters to affiliates. Two more staff guidance documents on SPACs followed in March and April, before Gensler announced his plans to put SPAC disclosures through a new round of rulemaking.
The March staff guidance on the audit obligations of SPACs sent a handful of firms back to the drawing board. Now there are reports that SEC examiners are asking pointed questions about how funds are managing compliance with the custody rule.
Some experts believe a SPAC exam sweep is looming. “We found SPAC personnel, back-office managers to be woefully undertrained compared to public companies,” says Julie Dixon, CEO of Waystone Compliance Solutions. “The SPAC is a sideline for a lot of people. They’re not used to working in a public market with a publicly traded company, and they’re just not as educated as they need to be.”
Sometimes staff guidance lays coiled for years before springing up. For example, the guidance that laid out the commission’s attitude for SPACs and the custody rule was issued by staff in 2014.
We spoke to compliance experts about how private funds can survive Gensler’s tenure as SEC chair. Here are their recommendations.
Use ‘cheat sheets’
Despite what private funds may think, the SEC isn’t trying to trap anyone, says Kurt Wolfe, a veteran securities litigator who is of counsel to Quinn Emanuel Urquhart & Sullivan. The commission regularly publishes risk alerts, staff guidance and exam priorities well in advance of showing up at your door. Use those papers as a kind of checklist for your firm’s compliance program, Wolfe advises.
“The risk alerts and exam priorities are the SEC at its best,” he says. “It’s like a cheat sheet. They’re telling you what’s going to be on the test.”
Last year, the SEC issued a first-of-its-kind risk alert for private fund advisers. Regulators reported that firms were struggling with fee and conflict-of-interest disclosures, as well as handling material, nonpublic information.
Focus on fees
When prepping for an audit, the best place to begin is with your firm’s fees and expenses, says Margaret Nelson, a former enforcement lawyer in the SEC’s Chicago office who is now a partner with Foley & Lardner.
“The SEC is always going to start with fees and expenses,” she says. “The first thing to do is a deep dive to make sure that all your fees are clearly disclosed, make sure that all your expenses and their allocations are disclosed and make sure your policies are firmed up.”
Avoid ‘hot topics’
Whatever you have heard from friends in other firms, it is folly to think you can stay ahead of regulators, says Igor Rozenblit, former co-head of the SEC’s Private Funds Unit and now managing partner of Iron Road Partners, a regulatory consulting firm.
“Focusing too much on perceived hot topics creates more risk than it eliminates,” Rozenblit says. “The SEC releases risk alerts and other guidance, which are very helpful, but don’t come close to addressing every issue that the SEC is currently working on.
“Many, if not most, of the truly important compliance issues being considered by the SEC are only revealed in public enforcement releases which happen many years after an issue is identified.”
Don’t wait for changes
Reframe your thinking about compliance. Instead of looking at it as a deadline to file some document, consider it another form of risk management, recommends Leslie Bailey, vice-president at LexisNexis Risk Solutions. “Just because you don’t have to from a regulatory perspective doesn’t mean it’s not good business,” she says. “If you think about, does your company want to be the one that’s tied to a terrorist fund or human trafficking? Just a mere mention of something in the press – where it’s not even a proven accusation – can really damage your firm.”
Follow the money
With examiners taking a closer look at private funds, it is essential they be able to account for every dollar, even in complex structures, says Vivek Pingili, director at ACA Group, a governance, risk and compliance adviser.
Under pressure from LPs over fees, some firms have ditched outside audits for their co-investment, friends and family, employee and liquidation funds. That is problematic. “A lot of people aren’t auditing those funds,” Pingili says. “Now we’re seeing regulators get tough, especially about private fund audits. Work with your auditors. The money flowing through all these funds – make sure you can account for all of it.”
You cannot be too careful. Even when fund advisers hire auditors, they are sometimes “getting bad advice,” he says.
“Auditors focus on generally accepted accounting principles,” he notes. “The difficulty is that the Custody Advisers Act Rule, 206(4)-2, is more stringent than GAAP. If the audit doesn’t pick up the flow of every dollar to every fund, there’s a gap there. Don’t just take the accountants’ word for it.”
Pingili urges private fund advisers to “have a game plan. If you’re not auditing a portfolio company, have a good explanation for why you’re not.”
Invest in compliance
When the SEC laid out its exam priorities for this year, regulators said they wanted to see “a culture of compliance” woven into the fabric of firms. “In the course of conducting thousands of examinations of many different types of firms, the hallmarks of effective compliance become apparent,” the commission wrote. “One such hallmark includes compliance’s active engagement in most facets of firm operations and early involvement in important business developments, such as product innovation and new services. Another is a knowledgeable and empowered CCO with full responsibility, authority and resources to develop and enforce policies and procedures of the firm.”
Private funds have traditionally struggled with this last bit. As many as three-fifths of chief compliance officers in private funds hold multiple titles, and firms stubbornly continue to view compliance as a cost center.
It is time to focus the whole business on compliance, says Julie Copeland, a partner with compliance consultant StoneTurn. “You’ve got to get the business on your side,” she says. “I consider it a revenue-protector, and I think that’s the way the business should look at it.”
Think your firm is too small to pour cash into compliance? In the past five fiscal years, the SEC has brought at least 77 separate enforcement actions against private fund advisers or their principals. The median amount of assets under management for those firms was $281 million. Only four firms had AUM above $5 billion.