ANALYSIS: Private Fund Adviser Rules Snub Emerging Fund Managers

It’s been six months since the SEC adopted new private fund adviser rules that disrupted the private fund industry. While there’s still time until private fund advisers have to comply, pending litigation is attempting to preserve the status quo.

And would this be such a bad thing? Emerging fund managers—fund managers without an extensive track record—will be impacted the most, and within this group, women and minorities will be among those most affected.

The Preferential Treatment Rule and VCs

One of the rules—the “Preferential Treatment Rule"—regulates a private fund adviser’s bespoke and more favorable arrangements (i.e. Most Favored Nation status, reduced carry or management fees) with individual investors, which are typically agreed upon through separate agreements known as “side letters.” As noted below, side letter provisions are critical to raising capital especially early on at the time of the fund’s launch.

The Preferential Treatment Rule prohibits private fund advisers from granting preferential redemption and information rights to some investors and not to others if the adviser reasonably expects such arrangements to have a material, negative effect on other investors in the fund. It should be noted that redemptions are generally not allowed under the Advisers Act definition of venture capital fund. Perhaps the most controversial of this portion of the rule is that if preferential deal terms are deemed to relate to any “material economic term,” the private fund adviser must provide all other investors in the fund with advance written notice prior to the investor’s investment in the fund.

As per the adopting release, “material economic terms are terms that a prospective investor would find most important and that would significantly impact its bargaining position” (and include “cost of investing, liquidity rights, fee breaks and co-investment rights”).

For all other preferential deal terms relating to illiquid funds, the rule requires notice to investors “as soon as reasonably practicable following the end of the fundraising period,” as described in the chart below.

Once mandatory (i.e., March 2025 for advisers under $1.5 billion in assets under management), the rules will require a private fund adviser to make a determination as to whether the preferential deal term contemplated is prohibited or whether it should be disclosed. One of the issues, though, is that if a fund manager grants preferential deal terms to an investor, the required timing of that disclosure hinges on whether the private fund adviser determines that the arrangement relates to a material economic term, an assessment that can be subjective, though the adopting release specifically identifies a few such arrangements that are considered material economic terms.

The Preferential Treatment Rule will likely impact fund managers in at least two significant ways:

• First, the added layer of providing investors with disclosures either in advance or soon after granting such preferential terms to certain investors in a fund may provide other investors with a good-faith reason to withdraw a commitment to invest, which can prolong the funding campaign timeline, and lower instances of closing the fund.
• Second, the new rules will make it much harder for would-be first time or emerging fund managers to attract an anchor investor.

One way to address the first issue is for the private fund adviser to be conservative and provide advanced notice to an investor of prior arrangements with other investors. There’s no clear path to overcome the second issue regarding the impact on emerging fund managers.

Rule’s Effect on Emerging Fund Managers

The new disclosure requirements were adopted to “address the risks and harms to investors and funds,” and to ostensibly level the information playing field for private fund investors. But they may do so at the expense of emerging fund managers.

Within the context of venture funds, being the first to commit to investing in a venture fund—especially with fund managers who have a strong track record— is a badge of honor for some investors. But being the anchor investor in a venture fund with an emerging fund manager can be somewhat bold. Getting this anchor investment is a critical vote of confidence, however, as it signals momentum to trailing investors and that the fund manager has a credible, fundamentally sound investment thesis (and, perhaps, access to deal flow).

Common side letter provisions typically used to draw in anchor investors have ranged from reduced carried interest and management fee provisions to terms granting investors co-investment rights, liquidity rights, and advisory committee representation in portfolio companies.

Under the new rule, small and emerging managers—many having limited working capital, less experience, and little leverage—will need to make important decisions early about which deal terms to extend to investors and whether certain terms offered to select investors require advanced or after-the-fact disclosure to other investors.

Further, the new rules may cause emerging fund advisers to have little choice other than to offer similar and competitive terms to all private fund investors once disclosures are made, which might result in squeezing their carried interest or management fee structures.

Given these scenarios, the reality is that the new SEC rules may only partially level the playing field: They provide venture fund investors access to more information, but the Preferential Treatment Rule impairs emerging fund managers. More established private fund advisers to venture funds will likely either not need to offer preferential treatment to select investors or, importantly, if they do, will have such a strong track record that informing other investors about preferential treatment granted to select investors won’t be a deterrent.

According to a report from the SEC’s Small Business Advocacy Office, for the decade ending in 2022, the total number of emerging funds has significantly outpaced more established funds. Notwithstanding this, 60% of dry powder is concentrated in mega funds with $500 million or more in commitments, and capital raised by emerging managers are at a 10-year low, according to a recent National Venture Capital Association report.

Importantly, emerging fund managers without a strong network of high net-worth investors will likely continue struggling to attract investors.

While these rules seem fair, how equitable are they?

Women, Minorities Struggle With Access

The emerging fund managers who struggle the most to attract investors are women and minorities.

Impact on Women Fund Managers

Women-owned firms raise smaller funds and struggle to raise capital from institutional investors. This matters within the context of venture capital funds, since women venture capital partners are “three times more likely to invest in startups with women CEOs,” according to a 2022 SEC Small Business Advocacy report, and women entrepreneurs face challenges accessing venture funding. If women fund managers aren’t supported, women entrepreneurs looking to raise venture funding will suffer.

Impact on Minority-Owned Funds

The same SEC report noted that only 1.4% of the total assets under management in the US were in minority-owned funds, and that Black-led first-time funds were only about half of the size of first-time funds raised by everyone else. Further, the report notes that 59% of Hispanic/Latino investment professionals work at smaller venture capital funds. This supports a widely known fact: if small and emerging fund managers are not sufficiently considered when issuing rules about the investment fund industry at large, diversity will suffer.

This dynamic causes ripples downstream, into the start-up ecosystem that funds and supports diverse founders since minority-founded venture funds are three to four times more likely to fund minority entrepreneurs, according to the SEC report. Minority startups that already struggle to raise venture funding will continue to suffer.

Bottom line: Once they have to comply with the Preferential Rule, emerging fund managers will struggle more, and of these, minorities and women will likely feel the effect the most.

Part two of this analysis will highlight other aspects of the private fund adviser rules that impact emerging fund managers and discuss alternatives that the SEC could consider.

For access to practical guidance for private fund advisers, visit Bloomberg Law’s Investment Adviser Compliance page.

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