Whether the US Securities and Exchange Commission’s (SEC) new private fund advisers rules eventually go ahead, and in what form, may still be a matter for the courts. But given mounting regulatory concern around the private market industry’s systemic importance, and the risks that may lurk there, greater transparency for the sector is coming.
Further SEC regulation for private funds is looming too – with the focus on requiring registered investment advisers to establish anti-money laundering programmes and report suspicious activity to the Financial Crimes Enforcement Network, as banks do under the Bank Secrecy Act.
The question is, how prepared are private market firms to handle these tougher compliance demands?
SEC rules put pressure on private market reporting
The SEC voted 3-2 on 23 August in favour of new private fund obligations under the Investment Advisers Act of 1940, in what has been termed the most sweeping new rules for the private funds industry since the 2010 Dodd-Frank Act was passed.
“The Securities and Exchange Commission has adopted new rules and rule amendments to enhance the regulation of private fund advisers and update the existing compliance rule that applies to all investment advisers,” the Commission said in a statement. “The new rules and amendments are designed to protect private fund investors by increasing transparency, competition, and efficiency in the private funds market.”
SEC-registered private fund advisers will have to “provide investors with quarterly statements detailing certain information regarding fund fees, expenses, and performance”, along with audited annual financial statements of each private fund. Adviser-led secondary transactions will require an independent fairness or valuation opinion from a third party.
In addition, all private fund advisers, regardless of registration status, will be prohibited from providing investors with preferential treatment regarding redemptions and information (for example, details of portfolio holdings or exposures) if it materially affects other investors. Any other case of preferential side letter deals offering more favourable terms to current and prospective investors must be disclosed.
Lawsuit raises implementation question marks
The changes are proving controversial.
Republican SEC commissioners Hester Peirce and Mark Uyeda condemned the rules as ahistorical, unjustified and harmful. The Managed Funds Association, Alternative Investment Management Association, National Venture Capital Association and three other industry bodies subsequently filed a lawsuit challenging the SEC’s adoption, citing Commission overreach. They say the rules will increase costs by imposing onerous disclosure requirements and administrative obligations, undermine competition and reduce opportunities for investors.
SEC estimates put the cost to the industry for the required audit statements and quarterly performance reports at $961 million annually. The regulations on unequal treatment of investors, plus the extra staff and legal costs connected to disclosures around fund expenses, would add another $938 million. Lawyers have indicated limited partners could ultimately end up bearing the cost of the enhanced reporting obligations.
SEC rules in practice
The lawsuit may yet prevail. But with the rules’ envisaged implementation date fast approaching (registered managers must comply with the new quarterly reporting requirements within 18 months of their publication), industry participants would do well to prepare for all eventualities.
So what do the SEC changes mean in practice?
Most general partners already issue quarterly reports to investors. The reforms though will require private funds to supply limited partners with far more detailed information that lays out their fund-level performance results. Advisers will need to provide line-item details of fees and expenses incurred by the fund, along with any additional compensation paid by portfolio companies to the manager. Fund advisers must also obtain and distribute an annual financial statement audit of each private fund they advise, as well as a valuation or fairness opinion.
All of which will place an additional strain on private funds’ data management and reporting capabilities.
Transparency depends on accuracy and control
Investors will need to be properly registered and their records maintained. Commitments have to be set up and monitored at each stage of the fund lifecycle, with tracking of all drawdowns, distributions, transfers and switches.
Income and expenses must be allocated appropriately to support accurate valuations and investor reporting. For private equity funds, waterfall and fee calculations have to be produced on both a whole fund and deal-by-deal basis, with close rebalancing and equalisation. Systematic control of all fee calculations is essential to ensure valuations are fast, accurate and consistent.
Generating performance metrics such as internal rate of return, time-weighted rate of return and total value to paid-in capital entails powerful data analytics. Firms will then need an automated reporting capability that can deliver customised, granular breakdowns of activity, positions and valuations, while ensuring full control over the reporting process.
End-to-end AML infrastructure
The prospect of SEC-mandated robust AML controls and suspicious activity reporting, if introduced, will add to private funds advisers’ operating demands – and risks if their capabilities fall short. As banks and other financial institutions have discovered, compliance rests on a multi-jurisdictional AML infrastructure that can deliver real-time visibility and control at every stage of the customer lifecycle, from client onboarding to ongoing client due diligence and real-time suspicious activity monitoring.
The entire private funds industry is reported to be gearing up to invest more on compliance and reporting technology in response to the SEC rules. With so much at stake, there is no room for delay.
ABOUT DEEP POOL
Deep Pool is the #1 investor servicing and compliance solutions supplier, providing cutting-edge software and consulting services to the world’s leading fund administrators and asset managers. Our flexible solution suite, developed by an experienced team of accountants, business analysts and software engineers, supports offshore and onshore hedge funds, partnerships, private equity vehicles, retail funds and regulated financial firms. Deep Pool is a global organisation with offices in Dublin, Ireland, the United States, the Cayman Islands and Slovakia. For more information, visit: www.deep-pool.com.