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The SEC’s latest adoption could take some negotiating power away from private investment fund managers and place it in the hands of LPs.
In a Wednesday open meeting, the SEC voted to approve a set of new rules and amendments to the Investment Advisers Act of 1940.
While more flexible than the initial proposal floated in February 2022, private fund managers will face prohibitions on preferential terms, a popular tactic used in negotiations between fund managers and their investors. Other key changes will require private funds to provide quarterly financial statements to investors and receive a fairness or valuation opinion on GP-led secondary transactions.
The SEC removed the controversial liability rule, which would have held fund managers legally responsible for negligence.
Investor protections
One of the new rules prohibits fund managers from forming preferential treatment agreements with LPs that include terms that will have a material negative effect on other investors. A material negative effect could include allowing an investor to exit a fund early, which William Birdthistle, director of the SEC’s Investment Management division, said could potentially dilute the value of remaining investors’ interest in the fund.
Another circumstance that could negatively impact other LPs is if a fund manager provides preferential information to an investor who could then use that knowledge to redeem investments ahead of other stakeholders.
“Even the most sophisticated investors cannot operate well in the dark with one hand tied behind their back,” Jessica Wachter, the SEC’s chief economist and director of the Division of Economic and Risk Analysis, said in the Wednesday meeting.
Preferential treatment usually comes in the form of side letters—peripheral agreements between PE funds and their investors—offering certain incentives to the LP. For fund managers entering into these kinds of agreements, lawyers argue that it might be difficult to determine what terms will or will not have material negative impacts on other investors.
“We still have this question, how does one interpret that?” Aaron Schlaphoff, a partner at Paul Weiss, said of the new rule.
Chairman Gary Gensler said the final rule was revised from the proposal to allow for more flexibility for GPs to offer preferential treatment to their LPs through side letters, as long as the terms are disclosed, and, in some cases, offered to all investors.
As such, the prohibition is subject to a series of exceptions. The new regulation will prohibit certain preferential redemption rights, with the exception of two circumstances: when redemptions are required by a law or a regulation, or when a GP offers the same redemption ability to all investors in the fund.
The legacy provision
The commission also included a legacy provision that will allow existing funds to be grandfathered in without having to renegotiate agreements with current investors—a welcome development, according to lawyers and service providers.
“I think that’s a huge, important piece of this, because no fund is going to want to go back and repaper their side letter agreements with their current investors,” said Amy Lynch, founder of compliance advisory FrontLine Compliance.
The new rule also prohibits GPs from offering certain LPs rights to preferential information about portfolio holdings and exposure. Again, the SEC added an exception to this rule that wasn’t included in the proposal: GPs can still offer this information as long as they offer the same terms to every other LP in the fund.
The LP-GP power balance
The new rules will bring more transparency into private fund negotiations, giving investors a clearer sense of what other LPs have negotiated for in the past, said Joel Wattenbarger, partner at Ropes & Gray. The influx of information available to investors about side-letter provisions that GPs have entered into with other LPs will change the dynamic for managers seeking capital allocations in the private markets.
“It will absolutely change the balance of power around side letter negotiations,” Wattenbarger said.
Despite the exceptions, Wattenbarger said the new rules around preferential treatment will be burdensome to investors, both in interpretation and application.
The new regulation will also require registered private fund managers to distribute quarterly statements to their investors related to information about the cost of investing in the private fund and the fund’s performance. Specifically, the statement will be required to include detailed accounting of all fees and expenses paid by the private fund during the reporting period, in addition to those paid by portfolio companies.
GPs will also be required to obtain an annual audit for each private fund under their umbrellas.
Additional rules and revisions
In the secondary market, fund managers engaging in GP-led secondary transactions will be required to obtain a fairness or valuation opinion from a third-party provider. In the initial proposal, the SEC included only an option for a fairness opinion.
The SEC said this rule is intended to combat any conflicts of interest that may be present in these kinds of secondary transactions.
The initial proposal also included a prohibited activities rule, which shifted to a restricted list of activities in the final documentation. Put simply, each restricted activity has a disclosure-based exception.
For example, the initial proposal prohibited private fund managers from charging their LPs for fees related to investigation and regulatory expenses. Under the final regulation, a GP can charge LPs these fees if they obtain the consent of each investor in their fund and get a majority interest of investors to approve it.
“I think that narrowing was important,” Schlaphoff of Paul Weiss said. “They really had some very broad prohibitions that would’ve been very difficult to operationalize.”
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