Saturday, February 12, 2022

Private Fund Rules

The SEC has been quite busy recently, and among other proposed rules, there’s this package of reforms that would impose some fairly dramatic new requirements for private funds.  The proposing release documents problems and conflicts in the industry that are both hair-raising and, really, quite well known.  In addition to just generally opaque fees and valuations, fund managers often charge fees to provide services to portfolio firms, which benefit the manager but eat into investor returns; some investors get preferred terms (extra liquidity, relief from fees, selective disclosures) that harm returns to other investors, and ultimately benefit the manager who can maintain relationships with the favored investors, and so forth.

So, in addition to requiring more disclosures to investors, audits, and the like, the SEC is also proposing to flat out prohibit certain practices.  For example, fees associated with a portfolio investment would have to be charged pro rata, rather than forcing some investors or funds to bear more expenses.  Funds would be prohibited from selectively disclosing information to preferred investors, or permitting them to have preferred redemption terms.  Advisors would be prohibited from seeking exculpation or indemnification from liability for breach of fiduciary duty, bad faith, recklessness, or even negligence with respect to the fund.

(It is of course difficult to miss how much these reforms kind of mirror issues that have come up in public markets.  The prohibition on selective disclosure sounds a lot like Reg FD; the prohibition on selective redemption ability calls to mind the mutual fund scandals from a couple of decades ago).

There are people who are much bigger fund mavens than me and probably have a lot more sophisticated thoughts, but here’s what immediately occurs to me:

First, I notice that in talking about the need for these rules, the SEC highlighted that funds give investors very limited governance rights.  For example, the SEC said:

Private funds typically lack fully independent governance mechanisms, such as an independent board of directors or LPAC with direct access to fund information, that would help monitor and govern private fund adviser conduct and check possible overreaching. Although some private funds may have LPACs or boards of directors, these types of bodies may not have the necessary independence, authority, or accountability to oversee and consent to these conflicts or other harmful practices as they may not have sufficient  access, information, or authority to perform a broad oversight role….To the extent investors are afforded governance or similar rights, such as LPAC representation, certain fund agreements permit such investors to exercise their rights in a manner that places their interests ahead of the private fund or the investors as a whole. For example, certain fund agreements state that, subject to applicable law, LPAC members owe no duties to the private fund or to any of the other investors in the private fund and are not obligated to act in the interests of the private fund or the other investors as a whole….

We have also observed some cases where private fund advisers have directly or indirectly (including through a related person) borrowed from private fund clients.  This practice carries a risk of investor harm because the fund client may be prevented from using borrowed assets to further the fund’s investment strategy, and so the fund may fail to maximize the investor’s returns. This risk is relatively higher for those investors that are not able to negotiate or directly discuss the terms of the borrowing with the adviser, and for those funds that do not have an independent board of directors or LPAC to review and consider such transactions.

Now, I don’t know if funds are typically organized under Delaware or another state’s law, but either way, this is really a great example of the push-pull interaction of federal and state authority over entities and “internal affairs.”  Mark Roe and Renee Jones have both written about how the threat of federalization of corporate law pressures Delaware to tighten its governance standards; this is a really dramatic example of the SEC saying that because state entity law does not contain investor protections and governance rights, it is necessary that the federal government assume that responsibility.  

Second, I note that institutional investors have been requesting these kinds of reforms for a while (for example); they obviously feel they cannot effectively bargain for the terms and information they need.  It really is a challenge to the current model of securities regulation, where we assume that institutional investors have the sophistication and bargaining power to protect themselves.  Commissioner Hester Peirce has already put out a statement decrying the proposed rules on precisely these grounds, i.e., that institutions don’t need the SEC’s protection, but if that’s so, what do you do when the investors ask for it?  If you don’t believe them, if you don’t believe they understand what they need and where they have insufficient bargaining power, then how can you justify Rule 506?  And if you do believe them, then, well … how can you justify Rule 506?

Third, there is a way to square that circle, and the SEC leans heavily into it in its proposing release: comparability.  Investors, even institutional ones, not only have collective action problems negotiating for terms and whatnot, but more than that, especially across investment managers, it may be very difficult to compare terms and returns.  And facilitating standardization is a task that government agencies are especially well-suited for.  Which is why the SEC repeatedly says that its proposed rules make it easier for investors to compare alternatives.

And then finally, there’s this:  To the extent funds are charging opaque fees and inflating valuations and whatnot, that seriously affects the allocation of capital, in ways that have real world economic effects. I’ve posted about this before in the context of startups, and it’s true with funds as well: the fund model may encourage some kinds of investments (leveraged buyouts, certain startup models) and not others, and if they’re wrong about what’s profitable, it ultimately not only harms investors, but all the employees who are left without jobs when the business fails, and even founders of competing businesses who can’t find capital because they don’t fit the fund model.   On the other hand, considering complaints about short-termism in markets today, I have no doubt that opponents of private fund regulation will particularly take issue with the SEC’s proposal for quarterly reporting; they will argue that doing so will eliminate private funds’ unique ability to focus on the longer term.

Ann Lipton | Permalink


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