Opinions are polarized on the 5th U.S. Circuit Court of Appeals ruling striking down the package of SEC private fund advisers rules. Although the court’s ruling was sweeping — vacating all five rules within the SEC final rule — it did so on narrow grounds, finding that the SEC did not have the authority to adopt the regulations.
But the court did not opine on the merit of the reforms themselves.
Leaving aside the question of SEC authority, the actual content of most of the rules in the package deserve support. In a global member survey conducted last October, the CFA Institute found widespread support for several key reforms sought by the SEC, though not all of them.
The findings represent the views of investment professionals in markets around the world. Three of the now-vacated SEC rules would have mandated quarterly reports to investors, annual audits and third-party fairness or valuation opinions on adviser-led secondary transactions. The CFA survey asked about all three reforms, but it did not say they were contained in the SEC rules.
Majorities in every market surveyed supported all three measures. Significantly, each measure received majority support among two key groups within the survey sample: those with experience as employees of institutional limited partners, which invest in private market funds, and general partners, which manage the funds. Specifically:
- 79% of survey respondents globally — and 70% in the U.S. — supported an annual financial statement audit of the private fund performed by an independent public accountant. Comparable or even higher levels of support were expressed by those with LP experience (83%) and those with GP experience (76%).
- 70% globally — 66% in the U.S. — supported a regulatory requirement for private fund advisers to provide fund investors with quarterly statements that include information on the private fund’s fees, expenses and performance. Likewise, 76% of those with LP experience and 62% of those with GP experience support the same.
- 61% globally — and 52% in the U.S. — supported a fairness or valuation opinion from an independent opinion provider of any adviser-led secondary transaction. Support totaled 61% among those with LP experience and 51% among those with GP experience.
Why the lower level of support, though still a majority, for fairness or valuation opinions of any adviser-led secondary transaction?
Perhaps respondents were signaling a mixed message: on the one hand, concern over potential conflicts of interest on the part of fund advisers seeking to launch a continuation fund; on the other hand, skepticism that a fairness or valuation opinion would resolve the conflicts.
Survey respondents may question whether external, third-party valuation opinions are truly independent. We can expect continuation funds to become increasingly popular and thus to continue to attract scrutiny. With the end of the era of cheap money, GPs are finding it more difficult to exit positions of the fund within its required time horizon. Continuation funds represent an attractive alternative, because they allow assets to be transferred to a new (or “continuation”) fund rather than sold at disappointing prices.
Other survey findings, however, were less favorable to the SEC rules. A slight majority of respondents globally (52%) and a near-majority (49%) in the U.S. supported new regulations — but only limited ones, not significantly expanded rules. Other responses were split between those who opposed any new regulations (27%) and those who favored significantly expanded regulations (19%).
Most CFAs also favored disclosure requirements but opposed outright prohibitions on private market practices. The SEC moved in that direction, replacing several proposed prohibitions with restrictions coupled with disclosure requirements. It is unclear whether the changes would have been enough to satisfy respondents.
Big LPs vs. small LPs
Some attribute the demise of the SEC rules in part to lukewarm support from LPs, who should have been the biggest supporters. If true, that illustrates one facet of the multilayered conflicts of interest in private markets, this one pitting large LPs against smaller ones.
LPs must engage in individual negotiations with the GP over fund terms, and big LPs investing large sums have the clout to obtain privileged terms for themselves alone. A privileged investor may receive a side letter with preferential terms that supersede the limited partnership agreement applying to all investors.
But smaller investors may obtain no special privileges and no side letters. They may not even know the details of privileges for larger investors. One of the SEC rules would have allowed preferential treatment only if disclosed in writing to prospective and current clients.
In the survey, just over half of all respondents (52%) and exactly half (50%) in the U.S. agreed that GPs should be required to disclose to prospective and current investors the terms of all side letters, while redacting any information that would identify the investor.
The drama over the SEC rules and the court decision paint a picture of sharp polarization. Just look at the split 3-2 vote by the SEC commissioners to adopt the final rule and the sharply worded statements of the two dissenting commissioners.
Yet the survey findings portray an altogether different picture. Survey questions repeatedly presented a spectrum of options, and in each case, only a minority of respondents selected either of the two extremes: that private markets have little or no problems or, on the contrary, that they suffer significant problems or market failures.
Instead, a plurality or majority of respondents consistently chose a moderate middle ground: Private market practices could be improved, but problems are not significant. For all the seeming polarization, the survey found the missing middle. Perhaps that is because the survey focused on investment professionals themselves, including those participating directly in private markets.
It stands to reason that LPs see room for improvement but are not overly critical of private market practices. Otherwise, why would they continue to invest billions into private markets? Indeed, respondents with LP and GP experience voiced similar views on most topics. The widest disagreement came over the adequacy of information on fees and expenses. Most GPs considered the disclosures adequate; most LPs, inadequate.
With the SEC rule vacated, industry best practices and self-governance become all the more important. The petitioners in the lawsuit extolled the role of private ordering in allowing private markets to flourish.
Their brief argued: “Private funds draw these investments by generating strong returns through tailored commercial arrangements that are only possible due to the existing market-based regulatory framework.”
Now that the petitioners have won their lawsuit, it is incumbent on private fund managers to join with investors to craft improved governance practices, including adequate disclosures for investors and resolution of various conflicts of interest. As both sides in the lawsuit agreed, millions of ordinary people — including police, firefighters, teachers and other beneficiaries of pension funds, those who rely on endowments and charities, and employees of companies financed or owned by private funds — have a critical stake in the success of private markets.
Stephen Deane, CFA, is the senior director for capital markets policy at the CFA Institute. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I’s editorial team.
