The SEC’s anti-competitive assault against private fund advisers

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The Securities and Exchange Commission is adopting new rules that radically redefine how investment companies are regulated, undercutting the ability of private fund advisers to do their jobs and forcing fund managers to disclose many of their actions to regulators. It amounts to the largest regulatory intervention between private investment managers and their clients since the Dodd-Frank finance law of 2010.

Specifically, the SEC voted 3-2 to adopt new rules governing the conduct of private equity and hedge fund managers. The rules will significantly expand the Investment Advisors Act of 1940, as private fund advisers—both regulated and currently exempt—are barred from displaying any preference when doing business with prospective investors.

The rules attempt to erase the longstanding distinction between registered investment companies designed for the general public versus private funds that cater to high-net worth individuals and well-staffed institutions. Commissioner Hester Peirce, voting against the proposal, called it “ahistorical, unjustified, unlawful, impractical, confusing, and harmful.”

The measure contains three individual rules tailored to SEC-registered advisers: the “Adviser-led Secondaries Rule”; the “Private Fund Audit Rule”; and the “Quarterly Statement Rule.”

The Secondaries Rule threatens to undermine the broad fiduciary discretion that Congress entrusted private fund advisers by diminishing their professional autonomy. It does so by requiring advisers conducting a secondary transaction to first obtain validation from an independent provider through a fairness or valuation opinion. The SEC’s rule second-guesses the expert opinion of fund advisers when managing transactions of subject assets.

The Audit Rule introduces a costly requirement for fund advisers to provide an independent financial audit statement for every private fund they advise. Serving as an extension of the Advisers Act’s custody rule, fund advisers must now distribute audited financial statements for managed funds to investors within a 120-day period before the fund’s fiscal year ends. Such audits will prove costly to prepare, particularly for undersized asset managers and advisers overseeing a large number of funds.

The Quarterly Statement Rule requires advisers to provide quarterly statements of fund-level information to investors revealing performance levels, fees, and expenses. While such transparency can be a good thing, this rule mandates the regular distribution of fund information regardless of whether the investor independently requested it or deems certain information to be valuable. Fiduciaries and their clientele, not government, should retain the right to choose whether such information is necessary.

Beyond the three rules pertaining to SEC-registered advisers, the measure contains two rules—the “Restricted Activities Rule” and the “Preferential Treatment Rule”—applying to all investment advisers, including unregistered professionals. It’s these two rules that stand out as the most controversial and restrictive among the entire measure.

The Preferential Treatment Rule seeks to end the issuance of “side letters” circulated by hedge fund managers to invite lucrative investments in exchange for granting special deals. Side letters are adjacent agreements between an investor and fund sponsor that goes beyond the standard investment. This component of the rule sees the SEC impose a set of anti-competitive safeguards—much like the Federal Trade Commission has recently done when pursuing anti-merger rulemaking—to prevent wealthy investors from having an “unnecessary” advantage. It does so by prohibiting investors from redeeming their fund’s interest when it imposes a material or negative impact on other investors. Additionally, advisers are prohibited from selectively disclosing information of a portfolio’s holdings to certain investors if such information is material or harms other investors.  

Perhaps the most controversial and challenged rule within this mandate has been the Restricted Activities Rule. Fund managers will be forced to disclose nearly every action they make to the SEC, including borrowing fund assets, revealing pre-tax and post-tax clawback amounts, and signed consent documents from investors regarding fees associated with investigations of privately held funds.

What was once a closed-door transaction left to the discretion of private fund managers and their partnered investors has now become public domain, courtesy of the SEC’s regulatory scrutiny. While SEC Chair Gary Gensler hails the final rules as a step toward “enhancing transparency,” this is yet another unfortunate attempt by the agency to expand its regulatory oversight to an area where its involvement was historically minimal.

The final rules provide license for the Commission to impose burdensome new disclosure requirements in the private fund markets. This follows a parallel trend of the SEC proposing new disclosure requirements that demand non-material information from public companies across the areas of climate change, cryptocurrency, and cybersecurity. As with the private equity disclosures, the SEC justifies such mandatory new disclosures as a means of gauging corporate risk. The most notable problem with these enhanced disclosures, however, is how the SEC is digging its claws into new policy areas beyond its organizational competence and jurisdictional control.

The success of such private equity partnerships hinge upon individualized, private relationships. Such relationships are facilitated in-part by a competitive process of vetting select investors based on internal preferences. Private fund advisers know best what is in the interests of their clientele, not the SEC. Intruding upon the ability of fund managers to wield discretionary selection between investment options frustrates two of the SEC’s core administrative pillars—maintaining efficient markets and facilitating capital formation. Affected fund advisers will struggle mightily to maintain candid and personal relationships with their clients when every engagement they make is now captured by regulatory disclosure requirements.

Such invasive disclosures will prove costly to prepare and difficult to maintain, especially when the potential for raising private equity is greatly diminished by the regulatory ban on side-letters and any range of conduct branded as preferential treatment. Alternative asset managers will also be forced to exhaust more capital to satisfy the rules’ annual auditing mandate and disclosure requirements for each supervised fund. Private investors must become cognizant of the SEC’s robust equity rules, which will undercut the traditional adviser-client relationship, while obstructing the means for alternative asset managers to raise capital.