SEC Signals Desire for Reevaluation of Private Markets Regulation

In our Q3 2021 private markets update, we analyzed the potentially significant ramifications for the private markets fund manager industry (and particularly the private equity and venture capital fund manager segments) arising from U.S. Securities and Exchange Commission (SEC) Chairman Gary Gensler’s high profile testimony earlier this year highlighting the need for increased scrutiny of, and potentially new rules aimed at, this industry.

Since then, we have seen multiple (and occasionally contrasting) public remarks from Chairman Gensler and other senior staff shining a spotlight on the astronomic growth of the private markets industry (both funds and operating companies). While in many of these instances it may be hard to ascertain the potential impact of these remarks on the future of private markets regulation (including the adoption of new rules) and the very nature of general partner (GP) – limited partner (LP) dynamics itself, one thing is clear: the increased intensity with which the SEC has been examining (and taking enforcement action against) private markets fund managers over the course of 2021 is very much in sync with the tenor of these public remarks.

As further evidence that the themes running through these remarks could actually translate into rule-making, the SEC’s recently released rule-making agenda states that the SEC’s Division of Investment Management is considering recommending that the SEC “propose rules under the Advisers Act to address lack of transparency, conflicts of interest, and certain other matters involving private fund advisers.” Irrespective of whether such a rule will materialize, it is reasonable to expect the SEC to issue formal guidance on these topics in 2022 (perhaps similar to the risk alerts on various private markets fund industry-related topics we saw in 2020).

Contrasting Remarks Before the Small Business Formation Advisory Committee

In his remarks in September 2021 before the Small Business Formation Advisory Committee, Chairman Gensler focused on the need for a reexamination of the special purpose acquisition companies (SPAC) disclosure rules (against the backdrop of an unprecedented recent surge in SPAC offerings, which typically offer private company founders the ability to transition to public company status on more preferential terms vis-a-vis a traditional IPO). Gensler’s comments are driven by a view to increase healthy competition in this burgeoning market – which he believes will be enhanced by requiring SPAC sponsors (including those simultaneously sponsoring private markets funds) to better inform investors (particularly retail investors) about the fees, expenses, dilution risks and other conflicts associated with investing in SPACs.

In contrast, in his contemporaneous and more laissez-faire-oriented remarks, Commissioner Elad Roisman shifted focus by highlighting how institutional investors have disproportionately benefited from the astronomic growth in the private markets, leaving “very few opportunities for retail investors to capture much of the considerable wealth that has been generated by some of our country’s most dynamic companies.” Commissioner Roisman went on to cite the largely positive experiences of pension funds and mutual funds investing in later-stage private companies (directly or indirectly) as notable exceptions to that general rule. He added how the risk/reward balance here has often been suitable for retail investors with moderate means – especially when factoring in: (i) the sophistication of the investment managers/other fiduciaries making investment decisions on behalf of the retail investors in such funds and (ii) such funds investing in private operating companies at a point in their respective lifecycles when some of the most significant start-up risks have receded. In contrast to the views of other senior SEC staff, Chairman Roisman opined that the types of enhanced disclosures that may be warranted when retail investors directly tap into private markets opportunities may not be necessary in the context of mutual funds and pension funds investing in the private markets. He closed by urging the SEC to creatively consider expanding the accredited investor definition to “allow more individuals to access potentially valuable investments.”

Emerging Collaboration between the SEC & ILPA

Additionally, in an early example of how the SEC and the Institutional Limited Partners Association (ILPA) appear to be joining forces more closely than in the past, is their shared agenda to reshape the nature of the GP-LP relationship for the increased protection of a rapidly diversifying investor base. Chairman Gensler’s remarks in early November 2021 at the ILPA Summit are especially noteworthy. These remarks come on the heels of a letter ILPA submitted to the SEC renewing its push for rulemaking designed to make fee-and-expense disclosures more consistent and comparable across the private markets fund industry.

Additionally, the increasing pressure from LPs and their representatives (such as ILPA and investment consultants), who are jumping on the bandwagon of a sympathetic SEC administration, is only adding fuel to this growing fire.

Certainly, now is as good a time as ever for private markets fund managers (especially those of who have increasingly taken on less sophisticated investors) to re-evaluate overall regulatory risks posed by their current business practices and the corporate governance frameworks they have in place to effectively mitigate and disclose material conflicts and other risks.

• Setting the Stage
  To set the stage for increased oversight (including via rulemaking), Gensler alludes to the diversification of the private markets fund industry over the last several years. The industry has significantly evolved from a LP-base comprising almost exclusively of the most sophisticated and largest domestic and foreign public pensions funds, sovereign wealth funds, college and university endowments, private foundations and ultra high net worth investors/mega family offices to one that, while still dominated by the foregoing type of LPs, is increasingly sharing the podium with less sophisticated public pensions funds, smaller endowments and foundations, and natural person investors (including family offices) with significantly less financial resources than large family offices.
• Fees & Expenses
  Gensler notes how the overall fees and expenses paid by LPs in private markets has increased. He is setting the stage to make the argument for a renewed scrutiny of whether these fees and expenses have been properly disclosed. In his remarks, Gensler cites a recent article in a major financial newspaper that portrays a very harsh (and at-times tabloid-like) picture of the private equity (PE) fund manager industry’s expensing practices. However, he omits how far the industry has come on the fees-and-expenses disclosure front relative to the pre-Dodd Frank era. After all, as our readers are well aware, Fund limited partnership agreement (LPA) fee-and-expense provisions have expanded from often vague one or two paragraphs to highly granular disclosures spanning multiple pages. In the coming months, many industry experts will likely caution the SEC to focus its energy on transparency and accountability (as opposed to second guessing what GPs and LPs have contracted with clear and open eyes). Certainly, it is worth taking stock that a significant segment of LPs in private markets have obtained fairly impressive returns and, for the most part, believe that the fees and expenses they are paying are justifiable in this context (even if they would like more granular reporting around certain types of fees and expenses to be able to better compare the performance of one manager versus another similarly situated one).
• Side Letters
  Gensler notes how side letters have expanded in number, scope, and complexity over the years. He particularly focuses on side letters that provide preferential fee arrangements for certain investors and cites a business school publication to make the point that similar-sized pension funds often pay significantly different fees across their investments in similar-type PE funds. He closes by noting that he has instructed his staff to evaluate how the SEC can help level the playing field around such preferential terms, or even consider banning certain types of side letter provisions (not specified). The latter proposal is something we have not seen from the SEC in a very long time and may alarm GPs broadly.
• Performance Reporting
  Gensler starts out on an upbeat note by noting that even net of all fees and expenses (after adjusting for leverage, liquidity, and risks), there is no doubt that private equity outperforms the public markets. He cites a JP Morgan study that highlights this outperformance, while cautioning how the gap is narrowing. However, taking a page out of recent public remarks from the IL State Treasurer and other public pension fund executives, he comments on how LPs can benefit from increased transparency and consistency around PE fund performance reporting. He concludes by noting that he has tasked his staff with evaluating what the SEC can do to promote this goal.
• Fiduciary Duty/Conflicts of Interest
  Gensler sends a strong reminder that contracts or agreements aiming to waive or reduce a PE fund adviser’s federal fiduciary duties are inconsistent with the Investment Advisers Act. This should serve as an important wake up call for GPs that even LPA provisions waiving Advisers Act protections in an effort to creatively reduce costs to LPs – for example, those where LPs waive custody rule protections (such as fund audits) - will not be tolerated by the SEC. Gensler concludes by noting that he has asked his staff to consider how conflicts in the private equity fund industry can be better mitigated and whether certain types of conflicts (not specified) should be banned.
• Form PF Reporting
  Gensler notes how a decade of Form PF reporting has provided the SEC with extremely valuable information on the opaque PE and hedge fund (HF) industries – which in turn has increased the SEC’s understanding of systemic risks these industries pose both on a micro and macro level. He adds that he has asked the staff to consider the need for more granular and/or timely reporting via Form PF (which could well mean that PE fund managers (in general or a subset thereof) could possibly in the future be required to report on Form PF more frequently (than once per year) and on a more comprehensive set of data points relating to their strategies/investments and potentially other aspects of their businesses.

Rare Focus on Private Markets Operating Companies

While SEC commentary on risks relating to investing in private markets funds is anything but rare these days, we do not often see SEC staff commenting on risks relating to investing in privately held operating companies (such as those that private markets funds invest in). As such, we think SEC Commissioner Lee’s fairly lengthy remarks at SEC Speaks in 2021 on a host of investment and broader economy-related risks relating to the operating company segment of the private markets industry may interest our readers. Below, we summarize the key themes running through Commissioner Lee’s observations and commentary.

• Astronomic Growth & Influence
  As demonstrated by the last two decades, private companies are staying private much longer than before (due to the increased availability of private capital) while their size and influence often dwarfs their public company counterparts. For example, 70% of new capital raised in 2019 was via private as opposed to public offerings.
• Impact of Lax Regulation
  Chairman Lee opines that this astronomic growth in private companies is not so much the result of free market forces but the result of relaxed regulation. Chairman Lee goes on to state that a combination of the vast capital available for private markets investments (including those attributable to private markets funds), relaxed legal restrictions and greater opportunities for founders and early investors to cash out, allows companies to remain in the private markets nearly indefinitely (with little incentives to go public, where they would be subject to more extensive regulatory requirements around the way they conduct business and disclose details about key aspects of their businesses, including material risks).
  
  Chairman Lee goes on to warn the private markets industry that decreasing incentives to raise capital in the public markets present significant problems for private markets as well (especially over the longer-term). She notes that “private markets may depend in large part on the ability to freeride on the transparency of information and prices in public markets;¹ as public markets continue to shrink, so does the value of that subsidy.”
• Lack of Transparency and Unfair Playing Field
  Despite the positives, given the increasing impact of private companies on virtually all aspects of our economy and labor force, there is a need to focus on whether and, if so, how private companies may hold an unfair advantage over public companies due to having to play by a different set of rules (or lack thereof) and the risks these pose to direct investors in such companies as well as the broader set of investors in our economy.
  
  Regarding lack of transparency in the private company space, Commissioner Lee adds “there is little public information available about their activities. They are not required to file periodic reports or make the disclosures required in proxy statements. They are not even required to obtain, much less distribute, audited financial statements.” She goes on to observe that board seats are often the only way to remain meaningfully informed and that the lack of information access is increasingly putting at risk private markets capital inflows attributable to retail investors investing indirectly via institutional investors (such as mutual funds and pension funds).
  
  Of particular note to private markets fund sponsors, she goes on to state that even the largest and most sophisticated investors that have the leverage to obtain more details about material investment risks than the average investor sometimes inexplicably fail to do so (she cites the Theranos debacle as a good example of this observation). She goes on to highlight the lack of consistency in disclosure obligations of private company operators by stating that “the disclosure obligations that do exist are mostly a matter of contract rather than regulation, an approach that may affect both compliance and accuracy.”
  • This observation is perhaps one of the most immediate to private markets fund managers and one that seems to have been broadly and whole-heartedly accepted by SEC examiners. As discussed, in our prior quarterly private markets updates, over the past few years (and especially since the onset of the COVID-19 pandemic), we have seen the SEC exam staff increasingly undertaking deep dive examinations into how private markets fund managers are assessing and monitoring investment-related risks at their prospective and current portfolio companies prior to and post investment. The nature, frequency, consistency and quality of reporting and other data private markets fund managers are obtaining from their portfolio companies are all current hot areas of focus for the SEC.
    
    Similarly, the SEC is assessing the robustness and consistency of contractual covenants private markets fund managers have negotiated with their portfolio companies relating to a host of data on material risks and metrics necessary to evaluate the valuation, growth curve, and other key aspects of these businesses that have a direct or indirect bearing on exit returns.

Finally, the SEC is also closely scrutinizing whether private fund managers are thoughtfully, consistently, and in sufficiently granular detail reporting to their investors on material issues (or potential issues) at their portfolio companies that they have uncovered through their risk monitoring efforts. A good illustrative example of this trend that we have seen over the past few years is the SEC’s consistent push in the private credit fund manager space to ensure such managers are not only thoroughly monitoring loan covenant breaches and defaults by their portfolio company borrowers (in the individual and in the aggregate) (economic and non-economic) and effectively tackling these issues in real time, but also, in as objective and consistent a manner as possible, evaluating whether such events are material and, if so, reporting these to investors in a timely and comprehensive manner.

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Download our Private Markets Quarterly Update

This is just one of many insightful articles included in our Q4 2021 Private Markets Quarterly Update. Download the full newsletter to learn about:

• Best Practices for Building and Implementing a Private Markets Compliance Program
• Insider Trading Focus: Multiple Recent SEC Charges Present Cautionary Lessons for Private Markets Fund Managers
• SEC’s Novel Shadow Trading Theory
• SEC’s Recent Sweep Enquiries Into Electronic Communications
• Custody Rule Focus: Noteworthy Recent Trends in SEC Examinations & Enforcement Actions
• SEC’s New Marketing Rule: An Update
• Noteworthy SEC Enforcement Actions The UK National Security and Investment Act of 2021
• Real Estate: Compliance Challenges for Open-End Real Estate Vehicles
• Effectively Managing Operational Challenges in Performance Calculation and Reporting
• ESG Update: UNPRI’s Next Reporting Period Delayed Until Early 2023

^{1. Such as, for example, the types of public company comparable data that many private markets fund managers are increasingly relying on, in the face of growing investor pressure, to more objectively and comprehensively evaluate the unrealized valuations of their portfolio companies.}