The private equity industry has reacted with alarm to sweeping new regulations introduced last month by the US Securities and Exchange Commission.
Keeping on top of compliance, regulatory requirements and individual obligations to investors are already major headaches for private funds. This compliance burden is set to become even more intensive once the regulations go into effect.
The new rules, running to more than 600 pages, are the most sweeping set of reforms for the private fund industry since the Dodd-Frank Act was passed in the aftermath of the 2008 global financial crisis.
The SEC argues that the new rules will protect investors by increasing transparency, competition and efficiency in the private fund market.
The industry maintains that the rules, even though watered down somewhat from what was originally proposed, will raise administrative costs, reduce competition and make it harder for institutions to invest in private funds.
On September 1, six US private equity and hedge fund trade groups sued the agency in a Texas court, arguing that it had overstepped its statutory authority.
New reporting requirements
With the objective of increased transparency, the final rules will require private funds to provide investors with quarterly statements detailing fund fees, expenses and performance.
Although most fund advisers already provide quarterly reports, the rules require standardised, detailed reports setting out line-item details of fees, expenses and additional compensation.
Fund advisers must also obtain and distribute to investors an annual financial statement audit of each private fund they advise as well as a fairness opinion or valuation opinion.
Restricted activities
The new rules prohibit fund manager activity that is "contrary to the public interest and the protection of investors". For example, managers will be prohibited from passing on the costs from investigations unless they have informed consent from investors.
They will also have to disclose any fees or expenses relating to exams, enforcement or other compliance matters.
Preferential treatment and side letters
Perhaps the most contentious and fought over aspect of the regulations relate to providing investors with preferential treatment.
The use of side letters to secure special rights for individual investors outside of the limited partnership agreement, which applies to all of a fund’s investors, has been growing in prevalence in recent years.
Preferential treatment contained in side letters could relate to fee discounts, specialist reporting information or securing seats on the fund’s advisory committee. Another popular provision is the inclusion of 'most favoured nation' clauses to guarantee an investor will obtain any favourable preferences granted to other investors.
Some of the impact of these new rules could be mitigated if the industry took a less manual and more technology-first approach to compliance.The tracking and management of all these individual obligations is a major pain point for private funds, particularly as the volume and complexity of side letters has grown.
An academic paper published in the Washington University Law Review found that the average word count of side letters has risen from 639 (pre-2005) to 4,983 (post-2014).
A private equity firm with 10 different funds could have hundreds of side letters attached to each fund. Many firms will rely on expensive outside counsel to manually track these obligations.
While the SEC backed away from banning preferential treatment all together, the final rules do prohibit preferential treatment that would have "a material, negative effect on other investors".
Otherwise, the new rules allow preferential treatment as long as the various different economic terms offered in side agreements are disclosed to all investors.
Counting the cost of the new rules
The new rules are likely to significantly increase compliance and reporting costs for private equity funds and it is hard to see smaller funds taking on these additional requirements without increasing fees for investors.
The requirements on disclosing preferential treatment will significantly increase the administrative time and resources needed to maintain, update and manage obligations.
They will also increase the complexity of fundraising as every new side agreement will need to be disclosed to every investor, which may in turn require new individual obligations.
There will be a real challenge in the tracking and flow of information during the closing process.
What’s more, the SEC did not define ‘material or negative effect’, so fund managers and their legal teams must make individual judgement calls on whether certain preferential treatment is allowed or not.
All in all, as a result of these new rules, the side letter, which has become a staple of the private equity industry, becomes a very complicated and legally challenged document. Perhaps one saving grace is that the new rules do not apply to existing contracts and agreements.
Mitigating the impact
Some of the impact of these new rules could be mitigated if the industry took a less manual and more technology-first approach to compliance.
To date, many fund managers rely on expensive outside counsel to essentially maintain excel spreadsheets to track side letter obligations as well as other reporting obligations.
The latest technologies can significantly improve this process, saving fund managers time and money as well as ensuring they do not fall foul of missed obligations or compliance requirements.
There can be little doubt that the compliance and reporting requirements of private funds is only going to keep increasing.Generative artificial intelligence systems for instance, which are based on large language models that have been trained to understand contracts and side letters, would give private fund managers the ability to search and find information they need across all their agreements in seconds or to compare clauses contained across hundreds of different side letters.
What’s next?
The new rules take effect 18 months after they appear in the Federal Register – that is unless the industry’s legal challenges are successful, and the SEC is forced to look again at its proposals.
Regardless, there can be little doubt that the compliance and reporting requirements of private funds is only going to keep increasing. Technology innovation can be part of the solution to help ease this burden.
Richard Robinson is chief executive of Robin AI
