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SEC proposals aplenty, the “RIC-ification” of private funds and the impact on clients

Insight 23 March 2022

SEC proposals aplenty, the “RIC-ification” of private funds and the impact on clients

On September 27, 2021, the Securities Exchange Commission (“SEC”) Asset Management Advisory Committee published recommendations (“Recommendations”) which felt like a remnant of the previous administration—proposals to open private funds to retail investors.

Sanne published an article outlining them, but also highlighted “headwinds,” including a new U.S. President and SEC Chairman, Gary Gensler, who were likely to be wary of, if not more hostile to, the industry. Since the start of the year, a slew of new and meaty proposed regulations on the private fund industry seemed to verify that analysis, however, in hindsight, we may have missed in those liberal Recommendations a preview of what may turn out to be the start of a fundamental change to the regulatory treatment of private funds in the U.S.

One premise of the Recommendations was to align the regulation of private funds with that of Registered Investment Companies (“RIC”) for retail distribution. The proposed regulations of 2022 take a strong step in that very direction. They include increased and frequent reporting on securities positions and certain portfolio events, broad disincentives and prohibitions against treating various classes of investors differently, and efforts to reduce the cost (and thus profitability) of private funds. Taken as a whole and with the expectation of more to come, we appear to be moving in a direction where private funds, which are designed for the most sophisticated of investors with bargaining power, are regulatorily looking like RICs, but with a more restricted investor base—i.e., accredited investors, qualified clients, and qualified purchasers.

Below, we summarize the proposed regulations in two ways— (1) outline the most impactful proposals on our clients, and (2) provide a fulsome review of all proposed regulations.

Amendments to the Investment Advisers Act of 1940[1]

On February, 9 2022, the SEC proposed a vast array of new rules and amendments to the Investment Advisers Act of 1940 (the “Advisers Act”). Some of these proposals are tasks our clients already perform (i.e., annual fund audits, periodic written fund statements, and written annual compliance review) or can easily achieve via an existing service provider (e.g., reporting on certain fees and expenses, which can be added to administrator statements).The most impactful of these proposals are the “Prohibited Activities Rule” and the “Preferential Treatment Rule”. The former will likely increase costs to the adviser, while the latter will likely require a fundamental change to the operations of most advisers. Notably, they apply whether the adviser is SEC-registered or not, including state-registered advisers and exempt reporting advisers.

[1] https://www.sec.gov/rules/proposed/2022/ia-5955.pdf

All private fund advisers would be prohibited from:

  • Charging certain fees and expenses to a private fund or its portfolio investments, 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 breaches of fiduciary duty and other threshold events
  • Reducing the amount of an adviser clawback by the amount of certain taxes
  • Charging fees or expenses related to a portfolio investment on a non-pro rata basis
  • Borrowing or receiving an extension of credit from a private fund client

These put a squeeze on profit centers and limit the ability to pass costs to the fund and its investors. Perhaps most significant is the inability to receive certain indemnities/limitations of liability. Virtually every fund Limited Partnership Agreement (“LPA”) and Private Placement Memorandum PPM (“PPM”) today contains some indemnity and limitation of liability in favor of the adviser and general partner. Firms will have to go back to their law firms to update those documents, which is just the upfront cost. The back-end cost is even greater due to the resulting heightened litigation risk and the likely rise in the cost of insuring the adviser.

The proposal prohibits all private fund advisers from providing:

  • Preferential redemptions terms from the fund;
  • Preferential information about portfolio holdings or exposures;
  • Any preferential treatment that has a material, adverse effect on other investors; or
  • Other preferential treatment unless disclosed to current and prospective investors.

Most advisers treat investors differently for various reasons or no reason at all. Almost all advisers treat the GP or employee investment vehicles differently, including allocation of fees, expenses, and the requirement to contribute capital. Fundamentally, the rule would require the adviser to look at every agreement, side letter, report/statement, or practice for all investors (including the GP) originating in every department, including marketing, portfolio management and investor services, to identify the ones that might have a “material negative effect” on other investors (and would therefore be prohibited. Any new practices would be subject to a similar analysis and approval process. At the moment, there is no guidance as to what “material, negative impact” means.

And “disclosure” does not appear to mean the more general kind to which advisers are accustomed. For example, simply saying some investors may pay different amounts based on the investment size won’t do. The SEC states that instead, the adviser must describe the specific fee terms, which would naturally create some fee pressure from similarly situated investors.

The proposal also makes certain “preferential treatment” impermissible on its face, such as preferred liquidity/redemption rights or more frequent portfolio information (a practice that is common but created issues in the great recession when some investors had early warning information about a fund and the ability to get out quickly).

The proposed Advisers Act rules should also be read in parallel with the SEC's Division of Examinations' Risk Alert, highlighting four key topics for private fund advisers to consider regarding their fiduciary duties. A summary of the proposals was covered by Sanne in a recent article[3].

[3] https://www.sannegroup.com/our-thinking/insights/2022/sec-risk-alert-certain-compliance-issues-for-private-fund-advisers/

Required of all advisers with private fund assets of at least $150 million, Form PF[4] is an annual (sometimes quarterly) filing of financial metrics of funds to aid the SEC in assessing systemic risk. Large hedge fund advisors ($1.5 billion+ AUM) and large private equity fund advisers ($2 billion+ AUM) provide additional metrics. The proposal would reduce the large private equity fund adviser threshold to $1.5 billion AUM, and introduce “current reports” which must be filed within one business day of the following events:

For large hedge fund advisers ($1.5 billion AUM)

  • Extraordinary investment losses over a rolling 10-business-day period
  • Significant increases in the total dollar value of margin, collateral, or an equivalent over a rolling 10- business-day period
  • Receipt of a notice of default by the fund on a call for margin, collateral, or an equivalent, resulting in a deficit that the fund will not be able to cover or address by adding additional funds
  • A determination by the manager that a fund is unable to meet a call for margin, collateral, or an equivalent
  • Default by a fund’s counterparty on call for margin, collateral, or an equivalent or other payment
  • A material change in the relationship between a fund and one or more of its prime brokers
  • Significant decline in unencumbered cash over a rolling 10-business-day period
  • Significant disruption or degradation of a fund’s key operations
  • Various events concerning withdrawals and redemptions

All private equity advisers

  • Adviser-led secondary transactions
  • General partner or limited partner clawbacks
  • Removal of a fund’s GP
  • Termination of the investment period of a fund
  • Termination of a fund

The proposal also requires additional disclosures from large private equity fund advisers:

  • The fund’s investment strategies, including an estimate of the percentage of investment capital deployed for each such strategy
  • Restructuring or recapitalization of portfolio companies subsequent to the completion of the fund’s investment period
  • Investments in portfolio companies in which another fund advised by the manager or such manager’s related persons invested in a different class of securities
  • Use of leverage at the fund-level
  • Financing of or extension of credit to portfolio companies by the manager or the manager’s related persons
  • The fund’s Controlled Portfolio Companies (“CPCs”) and the borrowings and liabilities of such CPCs

While the additional data gathering is unwelcomed and does not appear to add to the SEC’s mission of protecting against systemic risk, the greater burden of “current reports” will likely be rare occurrences.

[4] https://www.federalregister.gov/documents/2022/02/17/2022-01976/amendments-to-form-pf-to-require-current-reporting-and-amend-reporting-requirements-for-large

It is becoming clear that the SEC believes Form ADV is not sufficient on its own. Therefore, it proposes the addition of Form ADV-C for the private reporting of significant cybersecurity incidents,[5] and additions to Form ADV Part 2A for the public disclosure of cybersecurity risks and incidents. Notably, the proposal extends the requirements to Form N’s, the registration statement for RICs.

[5] https://www.sec.gov/rules/proposed/2022/33-11028.pdf

This amendment proposes a new Rule 13f-2 and Form SHO[6] for the monthly reporting of certain short sale activity, both of which were discussed in our recent update[7]. Within 14 days of month end, advisers would be required to report:

  • Eligible securities, which are:
    • For any equity security of an issuer that is registered pursuant to Section 12 of the Exchange Act or for which the issuer is required to file reports pursuant to section 15(d) of the Exchange Act in which the manager meets or exceeds either (1) a gross short position in the equity security with a US dollar value of $10 million or more at the close of any settlement date during the calendar month, or (2) a monthly average gross short position as a percentage of shares outstanding in the equity security of 2.5 percent or more; or
    • For any equity security of an issuer that is not a reporting company issuer as described above in which the manager meets or exceeds a gross short position in the equity security with a US dollar value of $500,000 or more at the close of any settlement date during the calendar month
  • End of month gross short positions
  • Daily trading activity affecting reported gross short positions

Most hedge fund managers have become accustomed to quarterly Form 13F position filings. Eligible advisers must now incorporate a monthly shorts filing, though their current Form 13F vendors should be able to help.

[6] https://www.sec.gov/rules/proposed/2022/34-94313.pdf

[7] https://www.sannegroup.com/our-thinking/insights/2022/sec-proposes-short-sale-disclosure-rule/

A word on beneficial ownership

In an article we issued a few weeks ago, we highlighted some of the main changes being considered by FinCEN in relation to beneficial ownership reporting requirements. Whilst subject to many exemptions that would likely apply to private funds, it is important to keep track of these changes in the current context of Russia/Ukraine, as several regulators (e.g., UK) have begun asking for more beneficial ownership on foreign owners of national property assets. The rapidly evolving political situation could mean that more beneficial ownership reporting may be on its way.

How can Sanne help?

Sanne’s team of experts spans a global office network and has a proven track record in assisting clients and entities administered through new compliance requirements. Our service offering is orientated around the provision of a full suite of asset class specialist fund and corporate administration services, including expertise across listed and regulated fund structures, loan agency and capital market specialisms. Please reach out to our team directly to find out how Sanne can assist you or your business.

To discuss how Sanne can assist you or your business, reach out to Daryoush, Michael and Paul.

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Fund Services
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Daryoush Niknejad General Counsel, North America - Dallas
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Michael Barakat Assistant Director - Dallas
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Paul Séjournant Director, Product Development - United Kingdom
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