The Private Fund Rule Debate Isn’t Over Yet

Groups representing investors as well as 11 pension funds are pushing back against a lawsuit attempting to reverse the PFA rule.


Illustration by II

The Securities and Exchange Commission’s private fund advisor rule, which went into effect in August, is driving a rift between the industry groups that represent private equity firms and those that speak on behalf of their clients.

Late in December, the Institutional Limited Partners Association, several industry groups, and 11 state pension plans, filed an amicus brief in support of the private fund advisor rule, which is being challenged by trade associations that represent private equity firms. The brief was filed in the United States Court of Appeals for the Fifth Circuit Court.

According to the brief, allocators benefit from the private fund rule by helping to eradicate some of the problems they face when negotiating with private equity firms. The brief also pushes back on claims by private equity firms that the SEC didn’t have the authority to pass the rule in the first place.

“The oversight role that the SEC plays in private funds is valued and deemed essential and accretive by the LPs as has been demonstrated multiple times over the past ten years now,” said Jennifer Choi, CEO of ILPA, by phone on Wednesday. “They are the only entity that has that ability to look over the shoulder of the GP to see where there are conflicts that come up.”

In addition to ILPA, the Council of Institutional Investors, the Chartered Alternative Investment Analyst Association, and 11 state pension plans signed onto the brief. Pension signatories include the California State Teachers’ Retirement System, the Public School Teachers’ Pension and Retirement Fund of Chicago, the District of Columbia Retirement Board, the Los Angeles City Employees’ Retirement System, the Los Angeles Fire and Police Pension System, and the State Board of Administration of Florida.

The private fund advisor rule went into effect this summer after months of debate. Among other things, the rule requires private equity firms to provide investors with increased disclosures around fund terms, costs, and fees. It also bars private equity firms from giving some investors preferential treatment, such as fee discounts.

“As I’ve stated at length, we don’t think this rule was perfect. They hit some right on, missed some others,” said John Bowman, president of CAIA Association, a professional certification body. “What we’re not intending to do is to sit and debate a point-by-point defense of the PFA or a response to the lawsuit. Rather, what this collective amicus voice is attempting to punctuate is support for the spirit of the rule.”

After the rule was passed, trade groups representing private equity firms immediately filed a lawsuit challenging the SEC’s authority to pass it — and some of the regulation’s provisions. “Each part of the rule is unnecessary, unworkable, and unduly burdensome — and the commission failed to establish otherwise,” according to the lawsuit initially filed by the private equity groups, which included the Managed Funds Association, the National Association of Private Fund Managers, the National Venture Capital Association, and others.

Private equity managers believe the rule “will result in increased fees, less competition, and decreased choice for institutional investors,” according to the MFA’s announcement of the suit. Managers also claimed institutional investors do not need the protections offered by the SEC’s new rule: These institutions, by their estimation, are massive, with vast resources available for contractual negotiations.

ILPA and its fellow brief signatories disagree.

Representatives of investors argue that, by default, negotiations have shifted in favor of private equity firms, which have significantly more time and resources to push back on requests by allocators. Although the lawsuit paints institutional investors as some of the most sophisticated in the world, the truth, according to ILPA and other signatories, is that many private equity investors are small healthcare systems, municipal pension funds, and tiny endowments.

“There are structural challenges in this industry that sophistication alone isn’t enough to overcome,” Choi said. Other signers of the brief include the Fire and Police Pension Association of Colorado, the Fort Worth Employees’ Retirement Fund, the Louisiana Municipal Police Employees’ Retirement System, the Missouri Department of Transportation and Highway Patrol Employees’ Retirement System, and the Washington State Investment Board.

The move to file the amicus brief underscores a deeper feeling among investors that the balance of power has swung too far in favor of private equity firms that manage capital on their behalf.

The investors claim law firms that represent private equity firms hold “outsized” control in the process of launching a fund and raising capital for it. The majority of private equity firms rely on just a few of these law firms for advice. Given that, these asset managers have an information advantage, the investors say, which allows them to start the negotiations from a place that is less favorable to asset owners.

As a result, allocators often feel like they start the negotiation process on their back foot, having to push for simple provisions related to transparency and fiduciary obligations. The private fund rule, they argue, makes these provisions the default position, and will help make negotiations focus on larger issues, such as the investment strategy and governance of the fund.

“According to LPs, it’s a slow but steady shift of negotiating power to the GP,” Bowman said. “All we’re saying is that we believe that we need to level the playing field. The ecosystem needs to have a public debate.”