The pendulum has swung

by Alice Murray 7 March 2022

The recent noise coming from the SEC is largely measured and unsurprising; as the asset class matures of course it should adhere to stricter oversight But what are the drivers behind the onslaught of proposed rules, and what does it mean for operational leaders?

When everyone is fat and happy we don’t talk about transparency, it’s only when we’re in distress that we all scramble for transparency.

There are two pendulums currently swinging in parallel. The SEC, under the Biden administration, is swinging from a culture of regulation to enforcement. “We’re in the middle of the swing,” observes Alan Halfenger, general counsel and chief compliance officer at Arctaris Impact, based in Boston. “The SEC can either be a regulatory or enforcement culture; I think they’re enforcement now.”

And that swing correlates closely to the private capital fund market’s maturity. On the surface, the clear signal of an asset class settling into adulthood is the massive growth it has experienced in recent years - from $3.8trn to a whopping $6.33trn during the pandemic, according to Preqin figures.

And that’s where the SEC’s recent deluge of announcements, risk alerts and proposals might jar with PE firms - and perhaps even LPs. “We’re in a weird time right now,” says an experienced PE and hedge fund CFO based in New York. “Over the past 18 months where the market has performed so well, I would say the desire for transparency and market performance are inversely correlated. When everyone is fat and happy we don’t talk about transparency, it’s only when we’re in distress that we all scramble for transparency.”

A closer look at PE shows deeper signs of a maturing asset class. The industry’s push in recent years towards data analytics and automation speaks to its increasing readiness and willingness to not only improve information flows, but also to harness their powers.

It is for this reason - for the industry’s proactive push into sophistication - that the SEC’s recent fund manager focused proposals should not be a cause for panic or fear. For the majority of managers, yes, it will require time and effort to digest and respond accordingly, but it is crucial to remember this is an exercise in closing loopholes; in creating consistency. Or, perhaps in more familiar terms, another milestone on the road towards standardisation.

Decent proposals

CFOs and compliance heads alike may well have seen a growing stack of papers on their desks over recent weeks. Here’s a power walk through the announcements and proposals.

First came the Form Private Fund (PF) proposal, which if implemented, would require private funds to disclose details of material events within one business day, compared with the current quarterly or annual requirement. For PE funds with more than $1.5bn in assets under management (up from the existing $2bn threshold) that could mean events including significant losses, termination of a fund, or disputes with LPs.

The thrust of this proposal is to provide the regulator with early warning signs that investors are in danger, or the financial system is at threat.

The following week (January 27th), the SEC published a risk alert, which identified four key areas of concern for the regulator - based on several months of examining fund managers. This is very much part of their job. “They’re doing good testing and they’re showing their findings,” says Halfenger.

And the findings of the alert didn’t come as much of a surprise to most. “On the substance side it’s a repeat, it feels like they’re saying ‘hey guys - we’re telling you again’,” adds Halfenger.

Then on February 9th, the Commission voted in favour of proposing new rules and amendments under the Investment Advisers Act of 1940 (Advisers Act) to enhance the regulation of private fund advisers and to protect private fund investors by increasing transparency, competition and efficiency.

This one is the motherload; a 341 page document, spanning vast swathes of fund management and governance. But, in a nutshell: the proposals would require funds to provide LPs with quarterly statements that provide granular accounting details on all fees and expenses paid by the fund, as well as paid by portfolio companies to the manager.

We need to talk

While there’s still a way to go before the final rules come into place - and until the rules are even finalised - unsurprisingly, all of this means more work for operational leaders.

With that, the immediate focus needs to be on getting to know the proposals well. Says Anthony Minnefor, partner-in-charge of EisnerAmper’s National Private Equity Services Group, “What’s interesting about these proposals is the SEC has posed a lot of questions, meaning the final form could be reasonably different to the current proposal. I suggest CFOs and CCOs monitor the developments and weigh in. They should comment on the provisions that are most meaningful to them.”

Indeed, following the publication of the proposals, the current consultation period provides important space for a two-way dialogue to take place. Already, there are some stand out questions that will likely command a large proportion of that discussion.

While the general direction of travel in the disclosure-related proposals are towards transparency and standardisation, as these new rules seek to protect investors, they suggest several prohibited activities. One of which is preferential fee arrangements or carry splits. “The proposal suggests making an even playing field. This section might attract more debate than any other section,” points out Minnefor.

More than that, the proposals go as far as abolishing the industry’s traditional fee structure. “There’s a whole section on the two and twenty model, and a question on whether it should be banned,” says Ben Cook, CEO of Colmore. “I don’t think that has legs; it’s important there is a management fee and income stream for GPs. But the issue is the gap in between: is it a fee? Does it apply to the fund?”

Also potentially up for the chop are certain types of expenses charged to the fund. “That generally creates lots of conversation. These things end up in the LPA for a reason - and they tend to evolve over time. People will go back around long standing discussions about what is appropriate to charge the fund and what is legitimate management cost,” adds Cook.

On the Form PF proposal, it has the potential to pick up everyday and more well accepted activities such as GP-led restructurings. The broader question raised by this proposal is what is risk? Like everything else, it’s relative. Determining what falls under the scope and what doesn’t, that’s the real challenge here. And if there is room for interpretation, more question marks arise, this time over the efficacy of the rule.

Fast paced

Beyond engaging and responding to the proposals, there is plenty more to be done before the rules are finalised and put in place.

According to Minnefor, many of these rules could come into play by the end of the year. “We’re in the second year of this Administration and with that the SEC would want an expeditious implementation of any rules. I think that could be prior to the midterm elections; that deadline could provide the impetus to move this through. I could see new rules coming into play by the end of the year.” And while the proposals are likely to change significantly, with many sections potentially removed, the direction of travel is clear; regulators (the SEC is not alone on this) are demanding transparency through uniform disclosure - i.e. standardisation.

The SEC has always said this - you can’t have a get out of jail card by blaming a third party, you have to have someone on the inside.

From farm to fork (from portfolio company to LP)

Despite major efforts to improve information flows between funds and their investors, the industry continues to battle with securing a fully fledged single source of truth. That’s partly due to legacy tech: “What we don’t have as an industry is that total throughput from portfolio company to manager. We have all of the information but it’s often sitting on different systems, which don’t always coordinate,” says Mike Trinkaus, CEO of 4Pines Fund Services.

But it could also be partly to do with understanding exactly what information needs to be collected. “I would expect to see more interaction with portfolio companies. There are sections of the report that require more transparency over the fees paid by portfolio companies to the advisor,” says Minnefor.

The haves and have nots

Regardless of how the final rules turn out, there will be new rules, which always have a disproportionate impact. For the largest managers, ensuring compliance will be nothing more than a tweaking of processes. KKR’s co-CEO Scott Nuttall said as much during a recent earnings call: “I think the level of regulatory scrutiny of our space is probably a positive for larger players that are more institutionalised. And so, there’s aspects of how the regulatory environment is developed that I think the barriers to entry in our space have gone up, and that’s good for incumbent players. So, nothing that we see that I would call out, today. Our job is to react to what the regulators talk to us about. And so far, we actually think it’s been long term helpful to our business.”

Indeed, large scale reforms could deepen the market’s bifurcation and see the largest managers attracting the lion’s share of institutional capital. “We’re going to see even more concentration,” says one US-based CFO. “The industry is becoming more a case of haves and have nots. We know that the best outperformance is funds one, two and three. But when it comes to underwriting risk and manager selection the divide will grow larger.”

At your service

So what can small and medium sized managers do to put up a good fight? Says Minnefor, “As it becomes more clear as to which provisions will stay, operational heads need to start building processes; to think about their own shop and where they need enhancements. That could mean new hires or expanding the reach of service providers.”

Indeed, service providers represent a huge source of support. “Fund administrators are probably better placed than GPs to figure a lot of this out; we’re incentivised to have tech and automation because that’s how we win and keep business,” says Trinkaus. “But the fund administration market also needs to make that transition as well; there’s still a lot of wood to chop. There are few folks with system connectivity that would allow for these levels of transparency.”

Inside job

Finally, perhaps the most important piece of this puzzle is putting compliance front and centre - as any mature and sophisticated asset manager would. “The SEC has made it clear that it’s ok to outsource a lot of compliance, they understand headcount is a pressure point for smaller firms. But they have also made it clear that they do not like a compliance officer for hire. They don’t want a third party person to be a signatory, they want it to be an inside person. That’s where you see the consistency in the messaging; the SEC has always said this - you can’t have a get out of jail card by blaming a third party, you have to have someone on the inside,” says a CFO source.

The increased scrutiny from the SEC in recent weeks should come as no surprise - the pendulum has been swinging this way for some time. Nor should the industry be overly worried. Yes, there are some spicier ideas in the proposals, but at their heart they are seeking to rightsize the level of regulation an industry of this size ought to operate under.

In understanding the SEC’s current thinking, it’s worth stepping right back and looking at how the financial investment landscape has dramatically shifted over the last two years. The lockdowns coupled with advances in technology have seen a major increase in retail investors participating in financial markets, be it equities or crypto currencies. And as markets become increasingly frothy, the financial watchdog is understandably looking to build in more robust protections. On top of that, retail investors are gaining access to private capital funds, and despite their lack of correlation to public markets, given the events of the past two years, the next downturn is likely to be unlike anything experienced before.

But away from the philosophy of the potential rules, the actual business of responding, implementing processes and ensuring compliance will fall on an already thinly stretched bank of resources. And perhaps this is where the revolution will take place; in bringing the already mighty operational burden of managing private capital funds to the fore - putting this vital work at the centre of fund formation, capital raising, LP negotiations and investor relations activities, as well as the way in which funds interact with portfolio companies. So that, at the end of it all, harmonious tech stacks, clean and healthy information flows and the holy grail of a single source of truth are simply the norm, commonplace, pedestrian even.

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