By Jennifer Dickinson, Senior Managing Director, U.S.
The 5th Circuit Court of Appeals recently vacated the Securities and Exchange Commission’s (SEC)private fund reform rules, making it unclear what will happen next with private fund reforms.
Commentary around the rules suggested that some of the problems the SEC sought to address could be solved by applying fiduciary duty principles and no rule was necessary. Indeed, the adopting release refers to these duties to explain their rationale. From a fund manager’s perspective, this means that firms should expect examiners to have the SEC’s concerns in mind regardless.
Finally, some of these rules dovetail with the current examination priorities, insofar as they relate to fees, expenses and valuations. Accordingly, we provide our thoughts on lessons firms can draw from some of the private fund reforms.
Preferential treatment
The preferential treatment rule would have required firms to (1) offer favorable liquidity and transparency terms to all investors; and (2) disclose all other material terms to all investors in a given fund. Importantly, the rule did not limit itself to side letters; it specifically scoped in any other forms of preferential treatment. Firms should take stock of their side letters and other mechanisms that provide preferential treatment. In doing so, the firm ensures that it understands all offered terms and can assess whether they still make sense to continue from an investor relations perspective.
Restricted activities
This rule restricted certain activities by either:
- Requiring investor consent (allocate costs of an investigation to the fund, and to obtain a loan from a fund), or
- Requiring notification to investors (allocating costs on any basis other than pro-rata, passing through compliance costs and offsetting clawbacks for the effect of taxes)
This rule highlighted the SEC’s concern that these activities aren’t in the best interests of fund investors, even if a fund’s documents permit them. Firms that engage in these activities may wish to consider ending some practices, such as borrowing from a fund, enhancing policies and procedures to ensure that non-pro-rata allocations have a reasonable basis, limiting the investigation or compliance costs that can be passed through and/or providing additional disclosures and notifications on any of these.
Adviser-led secondaries
This rule would have required firms to obtain a fairness opinion from an independent provider when engaging in a secondary transaction, such as forming a continuation vehicle. An opinion may not always be warranted, for example, in the case of funds that invest in Level 1 assets. However, in the case of funds that invest in illiquid assets, use side pockets or have other complexities, obtaining an independent opinion would help ensure a fair valuation, which could protect both the firm and fund investors.
Fund audits
This rule sought to close off the option of obtaining a surprise verification of client assets instead of a full audit. Some firms elected the surprise verification for smaller funds or special-purpose vehicles due to the efficiency and potentially lower costs. However, this route may not be suitable for larger funds with complex strategies, illiquid investments or unusual asset classes. Accordingly, firms should be aware that auditors may not be comfortable performing the surprise verification in a given case and recommend a full audit instead. Firms should also consider that sophisticated investors generally expect a full audit to be performed.
It’s advisable that firms review their practices and consider whether any policy and procedure updates should be made. An independent mock regulatory examination or gap analysis would also be helpful, as regulatory counsel or compliance consultants will have seen a wide range of other fund managers and bring valuable insights.
Ensure you stay compliant and keep on top of regulatory developments. At IQ-EQ, our compliance consultants have the experience to handle all U.S. regulatory requirements of the SEC and will work closely with you to keep your firm compliant in the face of new and evolving rules. Find out more about our U.S. compliance consulting services.
About the author
Jennifer is a Senior Managing Director for IQ-EQ, based in Chicago. She has over 15 years of experience involving compliance and legal matters for private fund managers (hedge, private equity, venture, real estate, and commodity pools), traditional investment advisors, family offices and commodity trading advisers.
