With so many proposed rules or rule amendments being issued by the Securities and Exchange Commission (SEC) during the first quarter of 2022, investment management firms, service providers and investors are left with more questions than answers.
One proposed amendment, if passed, could have a significant impact on private equity General Partners (GPs). This proposal would prohibit GP clawbacks from being net of fees, potentially leading to the resurgence of the American waterfall.
Sanne’s North American compliance team wrote extensively about several proposed rule changes, alluding to the “RIC-ification” of the U.S. private funds industry as it moves closer toward a European regulatory model. Many are questioning the SEC’s rationale and whether they notice the potential ramifications to fund managers and investors as well as the unintended effects on private markets overall.
“We are moving in a direction where private funds are regulatorily looking like registered funds but with a more restricted investor base – i.e., accredited investors, qualified clients, and qualified purchasers. If these advisers are limited to sophisticated investors but can’t treat them as such to reduce cost or liability, the natural result could be a mounting shake out over time.”
Today, American and European waterfalls are similar despite returns being accrued on a deal-by-deal basis with American waterfalls. Like European waterfalls, performance will be evenly distributed to Limited Partners (LPs) between deals. Depending on how deals perform, LPs could be made whole, and GPs could potentially take carry early. There is however a caveat if later deals don’t perform as well as planned. The GP clawback provision kicks in, where LPs will need to pay back the early profits if it is determined that they took too much from the fund.
Historically, the repayments have been net of taxes that the GP paid on the carried interest. Under perhaps the most controversial part of the proposal, GPs would be prohibited from repayment net of taxes, having potential detrimental effects on LPs depending on how GPs structure clawbacks.
“The private funds regulatory landscape is evolving at a rapid pace, placing increased importance on service providers that have established and extensive private market expertise, sophisticated and dynamic technology, and leadership that can work with GPs to navigate the increased complexity. To manage costs and ensure compliance with new regulations, private fund managers will lean heavily on their fund administration partner’s capabilities and knowledge of how to apply the regulation to the actual day-to-day fund operations.”
Although the new amendments are only proposals at the moment, it is evident from the SEC’s recent actions that there will be sweeping changes to the U.S. private funds regulatory environment. GPs can take steps now to prepare for potential changes by speaking with their fund administrator and legal counsel.
Sanne’s team of private equity experts spans a global office network and has a proven track record in assisting clients and entities administered through new compliance and private fund operational requirements. Our service offer is oriented around the provision of a full suite of private equity services, including expertise across fund formation, capital deployment, investment execution, all types of equity financing, restructurings and exits. Please reach out to our team directly to find out how Sanne can assist you or your business.