The SEC confirms increased industry scrutiny for private funds
He noted that the SEC had identified trends in the private fund industry, including growth in the numbers of funds, and new strategies, structures, and business practices. Gensler stated that US private funds currently have gross assets under management of $17 trillion with net assets of $11.5 trillion. With the significant growth in size of this sector, the SEC is now firmly focused on the need for greater transparency on areas such as expenses and fees arrangements and on leveling the playing field for investors, particularly with regards to preferential liquidity and disclosure terms inside letters to controls around material non-public information.
Read more about the SEC proposed rule here.
SEC Risk Alert: Deficiencies in Calculation Practices
The SEC’s Division of Examinations released a risk alert on 27 January 2022 outlining deficiencies it observed in its examinations of advisers’ fee calculation practices. The SEC highlighted these as including:
- Failure to act consistently with disclosures,
- Use of misleading marketing materials,
- Advisers not meeting their fiduciary duty by failing to conduct adequate due diligence of investments and service providers and the use of overly broad ‘hedge clauses’ in client agreements.
SEC Proposes New Rules & Amendments to Existing Rules
In comparison, on 26 January 2022, the SEC proposed amendments to Form PF, the form used by registered investment advisers to report information about the private funds they manage. The proposed amendments would change the reporting obligations of large hedge fund advisers, private equity fund advisers, and large liquidity fund advisers and are currently in the public comment period. Furthermore, the SEC has recently proposed a series of new rules and amendments to existing rules, under the Investment Advisers Act of 1940 applicable to private fund managers. The proposed new rules seek to, among other things:
- Require specified and standardized quarterly disclosures regarding performance, fees and expenses;
- Require registered private fund advisers, in connection with an adviser-led secondary transaction, to distribute to investors a fairness opinion and a written summary of certain material business relationships between the adviser and the opinion provider;
- Prohibit private fund managers from engaging in certain activities that are contrary to the public interest and the protection of investors;
- Require disclosure of, and in some cases limit, preferential treatment provided to certain private fund investors;
- Require that all private funds be subject to annual audit; add a written documentation requirement for annual reviews;
- Create requirements to keep records of compliance with the new proposed rules.
- Failure to act consistently with disclosures:
- advisers’ failure to seek consent from advisory boards or limited partner advisory committees (LPACs) as disclosed in offering documents, due diligence questionnaires and other disclosure documents, more specifically, failure to engage LPACs where there is conflicted transactions
- inadequacies in the calculation of post-commitment period fund-level management fees and use of undefined terms regarding impaired/written down investments without sufficient policies addressing how such terms should be understood with respect to fee calculations
- advisers extended fund lifetimes without obtaining approval as required in fund organisational documents, which caused advisers to earn management fees they may not have otherwise
- private fund advisers employed materially different investment strategies and exceeded limits on leverage, compared to what was disclosed in fund documents
- inaccurate disclosure or omission of material information in disclosures with respect to reinvestment of realised investment gains, which, in some instances, led to private fund investors incurring excess management fees
- Use of misleading marketing materials:
- Advisers did not accurately present performance track records, in fact, many advisers ‘cherry-picked’ certain fund performances, did not disclose the impact of leverage on returns and used performance that did not reflect the deduction of fees and expenses
- inaccurate calculation of performance returns, by, among other methods, calculating the performance over an inaccurate time period, incorrectly characterising the return of capital from portfolio companies and incorporating projected rather than actual performance
- advisers made misleading statements regarding awards they had received and had not included requisite disclosure regarding the criteria for obtaining the awards and fees paid in connection with receiving or marketing receipt of the award.
- advisers not meeting their fiduciary duty by failing to conduct adequate due diligence of investments and service providers.
- the use of overly broad ‘hedge clauses’ in client agreements such as a non-appealable judicial finding of gross negligence, willful misconduct, or fraud.
In summary, Gensler is seeking to increase SEC focus on the following areas:
- preventing private fund general partners from seeking waivers of their fiduciary duty – duty of care and loyalty
- private fund advisers’ disclosures of investment risks and conflicts of interest and whether these conflicts violate fiduciary duty
- valuation of assets
- controls around material non-public information.
Waystone has also observed increased focus from regulators in many other jurisdictions, including the Cayman Islands, where the Cayman Islands Monetary Authority (CIMA) has, within the last two years, also issued new rules around the calculation, valuation, and segregation of assets for private funds in an effort to increase transparency and enhance investor protection.
What does this mean for investment managers?
Gensler’s recent remarks, combined with the Risk Alert and proposed amendments clearly demonstrate that the SEC is prioritising transparency and integrity of fees and expenses and highlights a wide range of future focus areas for the SEC with regards to private funds. This will certainly have implications for exams, rulemaking, together with reporting and enforcement. In addition, Gensler indicates broader focus on investment adviser fiduciary duty, suggesting that some investment advisers’ practices may be in conflict with their duty of care and loyalty and may go so far as to constitute a violation of their federal fiduciary duty.
How can Waystone help?
Our core focus is to guide fund managers through the complexities of this environment with confidence. Waystone’s team of experienced professionals provide a range of fund governance solutions to ensure transparency, independence and oversight for a fund and its investors. With the industry’s largest team of full-time professional independent directors, our expertise is complemented by a comprehensive range of specialised investment fund governance services capabilities, providing a full-service firm for investment advisers and funds.
In addition, our US compliance and regulatory consultants have direct experience managing SEC regulatory compliance programmes for a range of private equity and venture capital firms as well as hedge fund managers. Our specialist professionals have spent more than 20 years in legal and regulatory roles for complex financial services organisations and are well placed to guide you through any new regulatory developments with regards to private funds.
If you would like to discuss these developments in more detail or find out more about how Waystone can assist you with your SEC-related compliance matters, please reach out to your usual Waystone representative or contact us.