The Securities and Exchange Commission took a big step forward Wednesday in proposing new rules on the notoriously opaque private fund business — covering everything from greater disclosure of fees and audits of returns to prohibitions of practices including charging fees to portfolio companies for unperformed services, deductions of taxes from clawbacks, and indemnification by investors in regulatory investigations.
Institutional investors have long complained about many of these practices, and the Institutional Limited Partners Association expressed support for the SEC’s move on Wednesday. “These proposed rules would importantly help address the increased prevalence of conflicts of interest in the industry, ensure that investors can validate that the fees and expenses that they are charged match what was contractually agreed, and deter practices that feed misalignment such as ‘shifting’ liability risks from private fund advisers to investors,” ILPA chief executive Steve Nelson said in a statement.
Private funds, which include private equity, hedge funds, venture capital, and others, now control $18 trillion. They can no longer be ignored by the SEC, Chair Gary Gensler said in announcing the proposed rules.
"Private fund advisers, through the funds they manage, touch so much of our economy,” he said. “Thus, it’s worth asking whether we can promote more efficiency, competition, and transparency in this field.” He said the proposed rules would “help investors in private funds on the one hand, and companies raising capital from these funds on the other.”
At the heart of the SEC’s new rules is an attempt to clean up practices that provide fund managers with benefits that hurt their investors.
“We have… continued to observe instances of advisers acting on conflicts of interest that are not transparent to investors, provide substantial financial benefits to the advisor, and potentially have significant negative impact on the private fund’s returns,” the SEC wrote in the proposed rule.
One of the often-cited complaints is the fees charged by advisers to private equity portfolio companies, which can end up putting a strain on the company’s finances and, eventually, its returns to investors. Meanwhile, the fund advisors have already profited.
“In many cases, the adviser can influence or control the portfolio company and can extract compensation without the knowledge of the fund or its investors,” the SEC wrote.
The SEC typically embraces a disclosure approach to regulation. In fact, the regulator in late January announced a proposal to expand reporting for certain investment advisors and private funds. Its willingness to outright prohibit certain activities came from the realization that they need to do more to stem abuses in private funds.
“We have observed certain industry practices over the past decade that have persisted despite our enforcement actions and that disclosure alone will not adequately address,” it said.
As a result, the SEC said it is “proposing rules that would prohibit all private fund advisers, including those that are not registered with the Commission, from engaging in certain sales practices, conflicts of interest, and compensation schemes that are contrary to the public interest and the protection of investors.”
It listed five categories of prohibited activities, including providing preferential treatment to certain investors in a private fund, unless the adviser discloses such treatment to other current and prospective investors, as well as charging certain fees and expenses to a private fund or portfolio investment, including accelerated monitoring fees.
Accelerated monitoring fees are those charged for services that “the investment adviser does not, or does not reasonably expect to, provide to the portfolio investment,” the SEC explained. (Ludovic Phalippou, a professor of finance at Oxford’s Said Business School and a critic of private equity practices, has called these fees “money for nothing” and a tax gimmick.)
These accelerated payments “reduce the value of the portfolio investment upon the private fund’s exit and thus reduce returns to investors,” the SEC said.
Other fees would also be prohibited under the new rule. Most funds charge a 2 percent management fee, which should cover all operational costs, according to the SEC. Instead, some funds have a pass-through expense model that the agency does not like.
The SEC said such expense arrangements have been on the increase. Its proposed rule would prohibit “an adviser from charging a private fund for fees or expenses associated with an examination or investigation of the adviser or its related persons by any governmental or regulatory authority, as well as regulatory and compliance fees and expenses of the adviser or its related persons.”
Eileen Appelbaum, the co-director of the Center for Economic and Policy Research and a longtime critic of the private equity industry, called the new rules a “huge step forward in overseeing the PE industry and its relationship to its investors.”
She noted, however, that the SEC did little to address the debate over how returns of private equity funds are calculated.
“The main limitation of the SEC’s initiative is that it makes no meaningful changes in the metrics PE fund managers use to report performance,” Appelbaum said. “There is still no standardization of how funds measure returns — whether they use subscription line loans to artificially increase measured IRR, for example, and how much of a buyout fund’s value is based on fund managers’ guesstimates of the value of unsold companies in its portfolio.”
The SEC did note that the ability of fund managers to value illiquid investments at their “discretion” creates a conflict of interest “if the adviser also calculates its fees as a percent of the value of the fund’s investments and/or an increase in that value.”
It also said that private fund advisers often use their existing fund performances to raise more money, raising “the possibility that funds are valued opportunistically and that the adviser’s compensation may involve fraud or deception.”
The proposed SEC rule would mandate audits by funds to ascertain whether their valuations are in accordance with GAAP standards. Only accountants registered with the Public Company Accounting Oversight Board would be acceptable as auditors.
Registered advisors would also have to file quarterly statements that include information about fees, expenses, and performance.
The proposed rules have a 30-day comment period.