Private equity in the US regulatory firing line

January 2024  |  FEATURE | PRIVATE EQUITY

Financier Worldwide Magazine

January 2024 Issue

Perhaps nowhere in the world is the impact of private equity (PE) felt more keenly than in the US. Private funds reported holding $20.4 trillion in gross assets by the end of 2022, versus $8 trillion about a decade earlier, according to the US Securities and Exchange Commission (SEC).

Today, PE deals account for more than one-third of all M&A activity in the US. Dealmaking is especially prevalent in the technology, healthcare, consumer, and financial services sectors. Though 2023 saw dealmaking, exit and fundraising activity fall amid spiking interest rates, PE firms remain active in the US, with many transactions benefitting from favourable tax policies.

Reforms

However, the winds of change are blowing. A major set of regulatory reforms was adopted and came into force in the US in August 2023. With a 3-2 vote, the SEC approved the introduction of the Private Fund Adviser Rules. The rules are expected to have a substantial impact on industry-wide business practices and greatly increase the regulatory burden.

Covering PE, real estate and hedge funds, the rules are designed to ensure that investors are protected, aim to stop confidential agreements that give some investors better deals than others, and limit the expenses that fund managers can charge their clients. They also include requirements for detailed performance reports to be published every three months.

According to Gary Gensler, chair of the SEC, the changes will benefit investors, typically wealthy individuals and institutional investors like pension funds, and companies raising capital from them. “Private fund advisers, through the funds they manage, touch so much of our economy. Thus, it’s worth asking whether we can promote more efficiency, competition, and transparency in this field,” he noted.

Initially proposed in February 2022, the changes will require PE firms and hedge funds to detail all fees and expenses on a quarterly basis. Firms are banned from charging customers for unperformed services or for adviser examination. Fund advisers, even those not registered with the SEC, are prohibited from conflicts of interest or giving any investor preferential treatment without disclosing it. The rules also lower the bar for investors to sue fund managers.

The Private Fund Adviser Rules consists of five sets of regulations and prohibitions referred to as the restricted activities rule, preferential treatment rule, quarterly statement rule, audit rule and adviser-led secondary rule. These will  apply to investment advisers differently depending on their SEC-registration status, their location, and the type and location of the private funds they advise.

These changes to the US regulatory landscape for the private funds industry will also impact non-US managers. Such entities will now need to review their current policies and operational practices to determine whether they need to adapt accordingly, either as a direct requirement of the Private Fund Adviser Rules or as an industry best practice.

Reaction

The new rules have not been universally well received. Industry groups and a number of funds have railed against them, claiming that the SEC is stepping beyond its purview by scrapping agreed-upon liability terms and banning specific fee models.

According to trade groups, the new rules will curb the entrepreneurialism, flexibility and investment returns of the private funds. Investors may also see higher fees due to rising liability risk for fund managers. Jennifer Han, chief counsel at the Managed Funds Association, argued that the rules would “increase cost, decrease competition and transparency and, as a result, harm investors by giving them fewer opportunities”.

Lawsuit

The Managed Funds Association and a group of PE and hedge fund trade groups responded to the rules by suing the SEC in the United States Court of Appeals for the Fifth Circuit, arguing that the SEC overstepped its statutory authority in adopting the new private fund adviser rules.

The lawsuit alleges that the rules exceed the SEC’s statutory authority, are arbitrary and contrary to the law, and were adopted in violation of the Administrative Procedure Act. The trade groups contend that these new rules would “fundamentally change the way private funds are regulated in America”, and asked the court to hold unlawful, vacate and set aside the rules, and grant additional relief as necessary and appropriate.

The outcome of the lawsuit against the SEC will be instructive. A favourable decision for the trade groups would hinder the SEC’s regulatory power under the anti-fraud provision in the Advisers Act and call into question existing regulations. If the court rules for the SEC, on the other hand, more expansive SEC regulations may follow. The PE industry will be watching with keen interest.

For now, it remains to be seen what impact these new measures will have on the PE industry in the US and beyond. In the meantime, heightened regulatory scrutiny of the PE industry will only add to the sense of unease across the global economy.

© Financier Worldwide

BY

Richard Summerfield