For the foreseeable future, the information imbalance between fund managers and their various limited partners may be in the hands of market players, not regulators.
Last week, a federal appeals court in New Orleans rejected the Securities and Exchange Commission’s recent amendments to the Investment Advisers Act of 1940, marking a major setback in the commission’s campaign to level the playing field for investors.
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The original rules—which the SEC voted into effect last August—intended to bring more transparency into private fund negotiations between GPs and LPs, largely by prohibiting GPs from forming preferential treatment agreements with fund investors and requiring funds to distribute quarterly statements to their LPs about fees and performance.
Back in August, I wrote about how these new rules could put more negotiating power in the hands of LPs by increasing the visibility that allocators have into these often-opaque, private funds.
Here was my thinking: In a typical fund, the larger the LP, the more sway it holds. The world’s largest institutional investors can ask for supplemental information about due diligence, fund performance and deals—intel that smaller LPs don’t have access to—in exchange for a generous capital commitment.
When it issued these disclosure rules, the SEC was, in part, aiming to level the playing field by requiring this kind of information be available to every investor in a fund—from the largest sovereign wealth fund down to the smallest single-family office. If one guy gets it, so does everyone else.
To take a hypothetical scenario, let’s say the portfolio managers at the Jessica Hamlin University endowment make a commitment to one of Blackstone‘s buyout funds. With $50 billion in assets under management, JHU’s investment staff has a lot of room to ask for information about the cost of investing and fund performance.
In the absence of the SEC rule changes, JHU can ask Blackstone to provide information about fund performance that other LPs (the $1 billion family offices) won’t see. Last week’s court of appeals decision—which the SEC isn’t expected to challenge—will uphold this asymmetry, keeping smaller LPs in the relative dark.
However, had the rule updates remained in place, the heightened transparency wouldn’t necessarily have put all allocators in the same sphere of influence, nor would they have dissolved the power imbalances between LPs in negotiating fund terms with GPs.
“It wouldn’t be the same degree of transparency across the board for investors—big and small—had these rules gone into effect,” said Joel Wattenbarger, a partner in the asset management group at law firm Ropes & Gray.
Some industry participants argue that the SEC’s efforts had adverse effects on both GPs and LPs, particularly by overwhelming GPs with fund reporting obligations and blunting larger allocators’ ability to negotiate favorable terms.
Some fund managers had to tell their larger LPs that they couldn’t offer deal-sweeteners in follow-on funds, according to Timothy Clark, global co-head of private funds and secondaries at law firm Freshfields. Sometimes, he said, this resulted in a fund losing its anchor LP on its subsequent vehicle.
Large investors “are often driving the fund terms generally,” he said. “Those are just the market conditions.”
Going back to my hypothetical, this would mean that Blackstone tells Jessica Hamlin University’s endowment that it can no longer share proprietary fund performance information with its investment team, because if it did, it would have to share the same information with all LPs, under the amendment guidelines. If JHU chooses not to invest in Blackstone’s next fund, it could slow fundraising and hurt smaller LPs.
Clark argued that the SEC’s efforts to change this dynamic were trying to solve a problem that didn’t exist.
Featured image by Drew Sanders/PitchBook News
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