Private Funds Exhale Over SEC Rule Despite Big Compliance Costs

Hedge funds and private equity firms are breathing a sigh of relief, welcoming concessions the Securities and Exchange Commission made when green-lighting a rule that imposes new restrictions and requires more fee disclosures.

The SEC adopted, by a 3-2 vote Wednesday, regulations aimed at increasing transparency in the multi-trillion-dollar private fund industry. But the agency eased—and in some cases abandoned—some of the most contentious parts of its initial proposal.

The SEC dropped a plan that would’ve exposed more fund managers to legal liability for mistakes, while softening its approach on side letters that give some investors special treatment. The final rule also permits various fund activities that would’ve been prohibited under the prior proposal, as long as they’re disclosed to investors.

“Relative to the proposed rules from last February, these final rules—from the perspective of private fund managers—are a substantial improvement in several respects,” said Joel Wattenbarger, co-head of the private funds regulatory practice at Ropes & Gray LLP.

The rule is still a significant change for private funds, which have faced light regulation. The Managed Funds Association, a trade group, said this week it was concerned the rule will increase costs and was determining next steps, including potential litigation.

There are problems with the rule, “just not as many as there could’ve been,” Peter Greene, co-head of the Investment Management Group at Schulte Roth & Zabel LLP, said.

Watering Down

The final rule is part of the agency’s push, under Biden-nominated SEC Chair Gary Gensler, to shine a light on private funds—a part of the finance industry with over $17 trillion in assets under management.

One of the most debated provisions was a proposed ban on private fund advisers seeking indemnification from investors for negligence in providing services to the fund. The hedge fund Citadel said in a comment letter filed with the SEC that the ban would significantly increase advisers’ liability risks in carrying out day-to-day operations.

The SEC removed the contentious language in the final version of its rule.

“If the proposal had been adopted, it would’ve meant that many funds no longer could operate in accordance with their governing documents,” said Michael Koffler, an Eversheds Sutherland (US) LLP partner and former SEC attorney.

Other actions that would’ve been prohibited under the proposed rule are now “restricted activities” that will be allowed with disclosure to investors and, in some situations, consent. That includes charging investors for regulatory investigations and compliance costs.

The final rule also eased proposed restrictions on side letters. Private funds say these side agreements, giving chosen investors preferential terms, can be important in helping them attract investors. The SEC argues that giving preferential treatment is a conflict of interest.

The final rule allows for special redemption rights and preferential terms for getting information about the fund’s portfolio holdings, as long as those terms are offered to all other investors. Under the proposed rule, such terms would’ve been prohibited.

Other preferential terms—such as offering an investor lower fees in exchange for a higher contribution—are also allowed if they’re disclosed to other investors. Under the final rule, advanced written notice to prospective investors is required only for “material economic terms.”

The SEC also added a legacy provision, allowing existing side letters with preferential treatment terms to remain. It’s a win for industry groups, avoiding what Greene said would’ve been a “practical morass” had funds been required to disturb prior side agreements.

The SEC is also providing legacy status to “restricted activities” that now require investor consent.

The Alternative Investment Management Association said in a statement that it welcomed many of the changes to the proposed rule. Other groups expressed disappointment that the SEC retreated from aspects of its original proposal.

“There is no adequate justification for weakening the reforms in the SEC’s original proposal,” Better Markets, which advocates for tougher financial rules, said in a statement following the rule’s adoption.

Significant Costs Ahead

Private funds, their lawyers, and industry groups continue to digest the rule. Initially, it wasn’t clear how the new consent requirements might work in practice, attorneys said. There could also be difficulties for funds in meeting the disclosure requirements, which can be quite specific.

“I do think that operationalizing that as a practice will certainly be onerous for managers,” Morgan, Lewis & Bockius LLP partner Christine Lombardo said, referring to the disclosure mandates.

Several industry-opposed provisions remained unchanged in the final rule.

Notably, funds must provide quarterly reports to investors detailing fees and expenses. While some advisers already provide similar reports, the rule’s requirements are a “very different world,” Morgan Lewis partner and former SEC attorney Christine Ayako Schleppegrell said.

Taken as a whole, the rule creates burdens and expenses for fund managers, attorneys said.

“It can’t be underestimated the cost that this is going to have,” said Kelley Howes, co-chair of the investment management group at Morrison & Foerster LLP.

The SEC has proposed separate rules that could affect funds as well. Those include a plan involving data analytics and another related to environmental, social, and governance investing. The prospect of a legal challenge to the newly adopted rules also looms.

“Stay tuned because today’s not the end of the story,” Wattenbarger said.