In the following guest post, Sarah Abrams, Head of Professional Liability Claims at Bowhead Specialty, discusses the updated compliance rules for Private Equity Firms and Hedge Funds, which the SEC released on August 23, 2023. I would like to thank Sarah for allowing me to publish her article on this site. I welcome guest post submissions from responsible authors on topics of interest to this site’s readers. Please contact me directly if you would like to submit a guest post. Here is Sarah’s article.
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On Monday, August 23, 2023 the Securities and Exchange Commission (SEC) voted to approve Private Fund Adviser amendments to the Investment Advisers Act of 1940, updating existing compliance rules for Private Equity Firms and Hedge Funds.
The initial proposal was floated in February 2022, so the SEC did provide the market with a heads up that there would be increased scrutiny over an industry that regulars have often referred to as opaque. Certainly, Big Law’s perspective that the new rules—which will take effect in 60 days—will likely create more work for law firm regulatory partners, as well as increase demand for recent public sector lawyers with regulatory agency experience,[i] seems the most realist forecasted impact.
Of course, the cost of counsel to comply with the new regulatory framework may itself have an impact on fund performance, as would the investigation and enforcement of disclosure requirements by the SEC.
“To enhance transparency, the final rules will require private fund advisers registered with the Commission to provide investors with quarterly statements detailing certain information regarding fund fees, expenses, and performance. In addition, the final rules will require a private fund adviser registered with the Commission to obtain and distribute to investors an annual financial statement audit of each private fund it advises and, in connection with an adviser-led secondary transaction, a fairness opinion or valuation opinion.[ii]
The creation of quarterly statements does not seem overly burdensome or costly in the cases where funds have portfolio companies of a certain size, which have gone public, or which have board oversight. Mandating quarterly reports on performance and associated fees, will require the disclosure of certain fee structures and mitigate the fund’s ability to give preferential treatment to certain investors.[iii]
“To better protect investors, the final rules will prohibit all private fund advisers from providing investors with preferential treatment regarding redemptions and information if such treatment would have a material, negative effect on other investors. In all other cases of preferential treatment, the Commission adopted a disclosure-based exception to the proposed prohibition, including a requirement to provide certain specified disclosure regarding preferential terms to all current and prospective investors.[iv]
Chairman Gensler said the final rule was revised from the proposal to allow for more flexibility for GPs to offer preferential treatment to their LPs through side letters, as long as the terms are disclosed, and, in some cases, offered to all investors.[v] Of course this will create a question as to what terms with certain investors will or will not have a material negative impact on other investors.[vi] A question that will undoubtedly lead to litigation. Another win for lawyers.
“In addition, the final rules will restrict certain other private fund adviser activity that is contrary to the public interest and the protection of investors… The final rules, however, will not permit an adviser to charge or allocate to the private fund certain investigation costs where there is a sanction for a violation of the Investment Advisers Act of 1940 or its rules.[vii]
This last sentence is the most important of all for the funds, the lawyers and financial lines insurers. Who is going to pay for the investigation costs?
Certainly regulatory coverage exists. With the above new SEC rules taking effect in the next 60 days, insurers covering SEC regulatory exposures should be ready for claims and potentially shifting underwriting loss ratios to account for anticipated legal expenses. Lawyers always get paid. Who pays for them will have a lasting impact to whichever industry (PE, Hedge, Insurer) that gets left holding the bills.
[i] “Big Law” is the term used in the legal industry to describe the biggest and most prestigious firms in the US; in this case firms that were cited in media sources included Ropes & Gray, Schulte Roth + Zable, Akin Gump Strauss Hauer & Feld, Simpson Thatcher & Bartlet. ‘They Didn’t Blow Up the World’: Big Law Reacts to New SEC Fund Rules | New York Law Journal
[ii] SEC.gov | SEC Approves Private Fund Adviser Reforms
[iii] ‘They Didn’t Blow Up the World’: Big Law Reacts to New SEC Fund Rules | New York Law Journal
[iv] SEC.gov | SEC Approves Private Fund Adviser Reforms
[v] New SEC rules could arm LPs with more negotiating power | PitchBook
[vi] New SEC rules could arm LPs with more negotiating power | PitchBook