Private Equity: Private No More?

On February 9, 2022, the Securities and Exchange Commission (“SEC”) proposed new rules under the Investment Advisers Act of 1940 (“IAA”) to regulate advisers to private funds. One set of the proposed rules is intended to enhance transparency through mandatory quarterly statements, annual audits, and fairness opinions in general partner (“GP”)-led secondary transactions. Another, and the more far-reaching, set of the proposed rules would prohibit certain activities, even to the extent of prohibiting or overriding negotiated fund terms.

Private funds are primarily hedge, private equity, venture capital and real estate funds. In 2021^*, registered investment advisers (“RIAs”) in the U.S. managed over 37,000 private funds with over $17 trillion in gross assets and almost $12 trillion in net assets. The principal categories of investors in these funds, based on net asset values, were other private funds (fund-of-funds) (17.7%), public pension plans (13.3%), private pension plans (10.8%), high-net worth individuals (10.2%), non-profit organizations (endowments and foundations) (10.0%), sovereign wealth funds (7.2%), and insurance companies (4.8%).

The SEC vote on the proposed rules was 3 to 1. In her dissent, Commissioner Hester Peirce called the proposed rules a “sea change” that “embodies a belief that many sophisticated institutions and high net worth individuals are not competent or assertive enough to obtain and analyze the information they need to make good investment decisions or to structure appropriately their relationships with private funds.”

The proposed rules are indeed an unintentional embarrassment for institutional investors in private funds. The managers of fund-of-funds, public and private pension plans, endowments and foundations have fiduciary duties to their investors and beneficiaries and are typically assisted by in-house or outside counsel in connection with their fund commitments. With its proposal, the SEC is effectively implying that these managers, despite their fiduciary duties and legal representation, regularly agree to fund terms they do not understand and thus must be protected like retail investors.

Summary of Proposed Rules

While the proposed rules would apply to all private fund managers, the following summary is intended for, and phrased in terms of the impact on, private equity firms. Note that the proposed rules summarized under 1 through 3 would only apply to RIAs, while those summarized under 4 through 6 would also apply to advisers that fall below, or rely on exemptions to, the registration requirement, such as managers of smaller private equity funds and venture capital funds. The proposed rules do not include a grandfathering provision and would therefore affect existing fund terms as well.

1. Quarterly Statement Rule

The proposed rules would require registered private equity firms to distribute a quarterly statement to fund investors in the form of a fund table with a detailed accounting of all fees and expenses paid by the fund during the reporting period. In addition, the fund table would disclose information regarding compensation or other amounts paid by portfolio companies to the manager or any of its related persons.

The proposed rules would also require private equity firms to provide information regarding each fund’s performance. The statement would provide the gross and net internal rate of return and gross and net multiple of invested capital to capture performance from the fund’s inception through the end of the current calendar quarter.

Private equity firms typically provide quarterly statements to their fund investors, but the details contemplated by the proposed rules with respect to fees, expenses and performance exceed current practice.

2. Private Fund Audit Rule

The proposed rules would require registered private equity firms to cause their funds to undergo a financial statement audit at least annually and upon liquidation, and to distribute the audited financial statements to investors promptly after the completion of the audit. This rule would be of limited practical impact, as standard private equity fund terms already provide for delivery of annual audited financial statements.

3. GP-Led Secondaries Rule

The proposed rules would require registered private equity firms to obtain a fairness opinion in connection with GP-led secondary transactions, commonly referred to as continuation funds. An independent party would opine on the fairness of the price being offered to the private equity fund for any assets being sold as part of the transaction. The proposal would further require the firm to prepare and distribute to the private fund investors a summary of any material business relationships the independent opinion provider has or has had within the past two years with the firm or any of its related persons.

4. Prohibited Activities Rule

The proposed rules would prohibit all private equity firms from engaging in certain activities and practices, including:

• Charging certain fees and expenses to a private fund or its portfolio companies, such as fees for unperformed services (e.g., accelerated monitoring fees) and fees associated with an examination or investigation of the adviser;
• Seeking reimbursement, indemnification, exculpation, or limitation of its liability for breach of fiduciary duty, willful misfeasance, negligence or recklessness;
• Reducing the amount of a carry clawback by the amount of income taxes;
• Charging fees or expenses related to a portfolio investment on a non-pro rata basis; and
• Borrowing or receiving an extension of credit from a managed fund.

This list is probably the most extraordinary aspect of the proposed rules. While labeled “prohibited activities,” the proposal is actually not prohibiting activities, but contractual provisions that are the result of a demand-and-supply process for fund terms. Some of the prohibitions may have a significant impact on private equity firms:

• Fund agreements typically exclude from indemnification and exculpation fund manager conduct constituting gross negligence. By mandating an exception for any form of negligence, the proposed rules could, with the benefit of hindsight, open the door for claims by fund investors that investment decisions made by the manager were negligent.
• The prohibition against deducting taxes paid from clawback amounts could require carry recipients to repay more in distributions than they actually received on a net basis.
• As noted above, the proposed rules do not contain a grandfathering provision and would override specific fund terms that may have been in place for many years.

5. Preferential Treatment Rule

The proposed rules would prohibit all private equity firms from providing preferential treatment to investors in a fund unless disclosed to current and prospective investors. One likely practical effect on private equity managers is that they will have to disclose all side letters to all investors, even to those who do not have a side letter with a Most-Favored-Nation clause. The disclosure of preferential treatment, however, would not be limited to economic terms or preferential terms agreed at the fund formation stage. In its proposing release, the SEC mentions as an example the grant of excuse rights to accommodate an investor’s unique investment restrictions, such as a mandate to avoid investments that do not meet certain ESG standards.

6. Books and Records Rule Amendments

The proposed rules include amendments to the books and records rule under the IAA that require advisers to retain records related to the proposed rules. The amendments would facilitate the SEC’s ability to assess an adviser’s compliance with the proposed rules.

Next Steps

The SEC is inviting public comments for 60 days from the publication of the proposing release on the SEC’s website or 30 days from publication in the Federal Register, whichever period is longer. As things stand, the comment period will end on April 6, 2022.

In its proposing release, which is over 340 pages long, the SEC asked for comments on a wide range of questions. Many of them show that the pendulum could swing even further in the direction of government-mandated fund terms. Here is a sample:

• “[S]hould we establish maximum fees that advisers may charge at the fund level?”
• “Should we prohibit certain compensation arrangements such as the ‘2 and 20’ model?”
• “Should we prohibit management fees from being charged as a percentage of committed capital and instead only permit management fees to be based on invested capital, net asset value, and other similar types of fee bases?”
• “Should we prohibit an adviser from being paid in advance for services it reasonably expects to provide in the future?”
• “[S]hould we prohibit deal-by-deal waterfall arrangements (commonly referred to as American waterfalls)?”
• “Are there other types of contractual provisions we should prohibit as contrary to the public interest and the protection of investors?”

Managers who want to protect the “private” in private equity, and who want to preserve principles of freedom of contract at least between sophisticated parties, should use the comment period to express their views and observe further developments carefully.

^*All data are from the Private Fund Statistics, dated November 1, 2021, of the SEC’s Division of Investment Management – Analytics Office.

This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.