SEC's new rules affect private equity, hedge funds and family offices

The latest sweeping rule change from the Securities and Exchange Commission targeting private equity and hedge funds affects family offices and high-net-worth investors by limiting preferential side deals known as side letters. It constitutes the sector’s biggest regulatory challenge in years.

The rule, passed last Wednesday, requires private fund advisers to supply investors with quarterly statements, including information on fees, expenses and performance; obtain an annual audit for each fund it manages; and acquire a fairness opinion in connection with an adviser-led secondary transaction.

It also bars advisers from activities and practices "that are contrary to the public interest and the protection of investors," unless they disclose certain information or, in some cases, receive consent from investors, according to an SEC fact sheet on the rule. 

Many industry groups expressed opposition to the rule proposal after it was first released in February 2022, though SEC Chairman Gary Gensler said during Wednesday's meeting that the final rule is sufficiently different from the proposal.

One aspect of the rule change that is likely to affect wealthy individuals and family offices is a provision that prohibits certain types of preferential treatment without disclosing such treatment to current and prospective investors. That change could have a cooling effect on co-investments as well as larger investors' ability to negotiate any sort of fee reduction, said Molly Diggins, Boston-based general counsel for placement agent Monument Group Inc. 

Pat Soldano, president of Family Enterprise USA, said the disclosure requirement is “concerning, as it could potentially put family offices and private investors more at personal and financial risk and make them think twice about investing in private funds.” 

So far, the reaction has been mixed, with some fund managers pleased that the final rules didn’t include proposals that would have significantly increased a manager’s liability risk.

“Regardless of the decision taken by the SEC, it’s clear that there will be additional regulations coming to the private markets as they continue to represent a growing proportion of investors’ portfolios,” Charlie Tafoya, CEO of Chronograph, a private markets data monitoring and insights company, said in a statement. “Regulations will put further burden on finance professionals to produce more timely information and provide additional regulatory disclosures.”

The rule change will be harmful to both asset managers and their investors, as it would increase costs and reduce investment options, said Bryan Corbett, president and CEO of the Managed Funds Association. The association will consider its “full range of options” including potential litigation, he said.

“More troubling, the SEC proposed these sweeping changes in a way that exceeded its statutory authority and lacked sufficient analysis of the impact of the rule on investors and markets,” Corbett said in a statement.

One of the more commonly cited problems with the proposed changes is that they are certain to increase compliance costs for fund managers. The burden, as usual, will be heaviest for smaller managers and those just starting out, who might not have the resources to comply.

Although some in the private funds industry are against the SEC’s proposals, citing numerous negative consequences for both investors and fund managers, in essence the rules will help align the U.S. market with the likes of Europe and Singapore, which both have more stringent regulation of alternative asset managers.

"The devil will be in the details," said Paul O'Shea, senior vice president and head of fee services at Preqin's technology and services company, Colmore. "Market participants will be looking keenly to see what version of the SEC's proposals make it into law," O’Shea said. Colmore's own research found that among recent-vintage funds, many already provided enhanced fee disclosures, he said. 

With additional reporting by Courtney Deegan and Arleen Jacobius of Pensions & Investments, a sibling publication of Crain Currency