SEC Chair Gensler Signals Increased SEC Scrutiny of Private Funds

Securities and Exchange Commission Chair Gary Gensler addressed the Institutional Limited Partners Association (ILPA) Summit on November 10, 2021. During his remarks, he outlined a potentially more expansive role for the SEC in regulating private funds.¹ After describing the historical context of the SEC’s regulation of asset managers and private funds, Chair Gensler stated it is time “we take stock of the rapid growth and changes” in private funds and begin to “bring more sunshine and competition to the private funds space.” To that end, Chair Gensler outlined three principles forming the basis of how he intends to guide the SEC in its oversight of private funds:

• Efficiency, competition and transparency,
• Market integrity, and
• Resiliency

Chair Gensler suggested that the effort to promote efficiency, competition and transparency should focus on fees and expenses, side letters, and performance metrics. SEC efforts to improve market integrity would emphasize the importance of fiduciary duties and conflicts of interest. Promoting additional financial resiliency will likely consist of “freshen[ing] up” Form PF. Chair Gensler’s remarks could well be a harbinger of further changes in how the SEC regulates and examines advisers to private funds, particularly in the context of fees and expenses, side letter arrangements, transparency and conflicts of interest – with the potential that the SEC could prohibit certain private fund practices in these areas entirely.

Efficiency, Competition and Transparency

Fees and Expenses

Noting that private funds currently hold approximately $9 trillion in net assets under management with fees and expenses estimated at $250 billion each year, Chair Gensler questioned “whether fund investors have enough transparency with respect to these fees.” New transparency rules would require “consistent, comparable information [investors] need [in order] to make informed investment decisions.” Chair Gensler noted that mutual fund fees have decreased in recent years, while private fund fees generally have not. He suggested that increased transparency and competition “could potentially bring greater efficiencies[,] ... lower the cost of capital for businesses raising money [and] raise the returns for ... investors.” He noted that, in addition to management and performance fees, many private fund investors bear other expenses, including fees charged to the funds’ portfolio companies.

The Chair called upon the SEC staff to consider recommendations to increase transparency of private fund fee and expense arrangements. His statements to ILPA are consistent with testimony he gave to the Senate Committee on Banking, Housing and Urban Affairs (Senate Banking Committee) during his confirmation hearing, when he observed, in response to a question from Senator Elizabeth Warren, that “it’s at the heart of the [Investment Advisers Act of 1940] that [private equity funds] would [disclose] their fees and any conflicts [to] their investors.”²

Private fund fees and expenses have been an area of concern for the SEC for nearly a decade. The SEC began focusing on private fund fee arrangements in 2012, when many private fund managers first registered under the Advisers Act as a result of the Dodd-Frank Act, which changed investment adviser registration requirements. Since then, the SEC’s Division of Examinations³ has considered private fund fees and expenses as part of its annual examination priorities.⁴ In 2020, OCIE issued a risk alert that called upon private fund advisers to evaluate their practices, policies and procedures in light of deficiencies related to fees and expenses.⁵

Side Letters

Chair Gensler expressed concern that certain side letters negotiated with limited partners (e.g., relating to preferred liquidity terms or reduced fees) could “create an uneven playing field.” He indicated that he had asked the SEC staff to consider recommendations to address these concerns and strengthen transparency, as well as recommendations regarding whether certain provisions of side letters should be prohibited entirely. While Chair Gensler recognized that certain side letter provisions (e.g., those related to an investor’s tax treatment) are “benign,” he further indicated that he had asked the staff to consider “how we can level the playing field and strengthen transparency, or whether certain side letter provisions should not be permitted.” Mandatory disclosure (and, even more so, prohibition) of specific types of side letter provisions would mark a significant change in the SEC’s regulation of private fund managers.

By contrast, the EU recently has sought to address similar concerns. For example, alternative investment fund managers (AIFMs) have transparency obligations whereby they must disclose to all investors any preferential treatment received by a particular investor, including by way of a side letter.⁶ Should the SEC require more transparency into side letter provisions or should certain types of side letters be prohibited, prospective limited partners might have less opportunity to negotiate different terms than under the current regulatory regime.

Performance Metrics

In addition to a need for transparency of fees and expenses, Chair Gensler highlighted the lack of transparency of private fund performance metrics. The Chair expressed his view that, unlike mutual funds, which provide detailed public information, relatively fewer facts about private fund performance are made available to their investors, much less to the public. He voiced concern that investors therefore might have difficulty analyzing the performance of private funds as compared to registered funds. Chair Gensler indicated that he had asked the SEC staff to consider how to enhance the transparency of performance metrics.

Market Integrity

Chair Gensler observed that general partners routinely seek waivers of their fiduciary duties at the state level, which he characterized as a concern for certain limited partners. Specifically, he noted that almost half of all institutional investors reported that general partners modified the scope of their fiduciary duties in new capital allocations. The Chair’s remarks suggest that the SEC and its staff might focus increasingly on managers’ fiduciary duties and conflicts of interest for private funds.

The Chair reiterated the SEC’s position announced in recent SEC interpretive guidance on adviser standards of conduct,⁷ that “[a]n investment adviser to a private fund has a federal fiduciary duty to the fund enforceable under the Advisers Act [that] may not be waived ... regardless of the sophistication of the client;” but he stopped short of applying the same principle to waivers of state fiduciary duties. Chair Gensler did, however, remind advisers to private funds that their actions need to be consistent with the adviser’s fiduciary duties, and he suggested that there is an opportunity to address conflicts of interest in a way that would “strengthen trust in the private funds market.” In this respect, the Chair called on the staff to consider how the SEC “can better mitigate conflicts of interest between general partners, their affiliates, and investors [,]... includ[ing] considering the need for prohibitions on certain conflicts and practices.” This appears to go further than the Chair’s September 14, 2021 testimony before the Senate Banking Committee, where he mentioned the possibility of “enhanc[ing] disclosures” regarding conflicts of interest among private fund managers.⁸ While new disclosure rules would be consistent with the SEC’s traditional approach to conflicts of interest regulation for investment advisers, prohibitions of particular practices in this space would break new ground.

Resiliency

Chair Gensler explained the steps he believes the SEC could take with respect to private fund oversight to increase financial resiliency. Since taking effect in 2012, Form PF has remained the principal systemic risk disclosure that private fund managers are required to file with the SEC. The intent of the form is to: provide the SEC and its fellow financial regulators with insight into the activities and potential risks of particular funds, fund managers and, ultimately, the industry at large; and enable regulators to identify, monitor and respond to potential risks that might be posed to fund investors or the U.S. financial system. Chair Gensler expressed his belief that “more granular or timelier information would be useful” to help promote greater transparency and allow regulators to better understand financial events and promote resiliency. In this respect, he stated that “the role of hedge funds was not immediately apparent in the March 2020 dysfunction in the Treasury market.” Chair Gensler indicated that the staffs of the SEC and the Commodity Futures Trading Commission, as well as the Financial Stability Oversight Council, Department of the Treasury and the Federal Reserve, are coordinating on potential joint rulemaking in this area.

Conclusion

Chair Gensler’s remarks to ILPA suggest that the SEC is likely to be active in the private funds space in the coming months and years. Notably, private fund managers (and investors) can expect potential new rules involving: side letters; possible prohibitions on certain practices that give rise to conflicts of interest; and transparency into fees and expenses. In particular, the SEC’s Fall 2021 Regulatory Flexibility Agenda includes references to potential rule proposals that would “address lack of transparency, conflicts of interest, and certain other matters involving private fund advisers” as well as potential amendments to Form PF.⁹ While the precise scope of any new rules remains uncertain, Chair Gensler’s remarks suggest that the rules could be significant and possibly herald a sea change in the SEC’s approach to regulating private funds and their advisers. Further, the SEC’s Divisions of Examinations and Enforcement also are likely to be more active as the SEC places a greater focus on its oversight of the industry.

Footnotes

1) Gary Gensler, Prepared Remarks at the Institutional Limited Partners Association Summit (Nov. 10, 2021). Unless otherwise noted, all quotes in this OnPoint are from Chair Gensler’s speech to ILPA, a trade association that represents institutional investors in private equity funds.

2) Gary Gensler, Testimony Before the United States Senate Committee on Banking, Housing, and Urban Affairs (March 14, 2021).

3) In December 2020, the SEC renamed the Office of Compliance Inspections and Examinations (OCIE) as the Division of Examinations.

4) See Examination Priorities for 2015, Examination Priorities for 2016 and 2020 Examination Priorities. For further information, please refer to the following Dechert OnPoints: SEC 2016 Examination Priorities Focus on Retail Investors, Market-wide Risks and Data Analytics and OCIE Releases 2020 Examination Priorities.

5) See SEC Risk Alert: Observations from Examinations of Investment Advisers Managing Private Funds. For further information, please refer to Dechert OnPoint, OCIE Publishes Risk Alert Regarding Recent Focus Areas in Private Fund Adviser Examinations.

6) Although AIFMs must disclose preferential terms granted to a particular investor, AIFMs need not disclose the identity of the investor receiving such preferential term. See Alternative Investment Fund Managers Directive (AIFMD) Art. 23.

7) See SEC, Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Advisers Act Release No. 5248 at n.31 (June 5, 2019) (“[A]n adviser's federal fiduciary duty may not be waived, though its application may be shaped by agreement …. [The release] does not take a position on the scope or substance of any fiduciary duty that applies to an adviser under applicable state law.”).

8) Gary Gensler, Testimony Before the United States Senate Committee on Banking, Housing, and Urban Affairs (Sept. 14, 2021).

9) See Fall 2021 Regulatory Flexibility Agenda (Agenda). The Agenda lists both “Amendments to Form PF” and “Updates to Rules Related to Private Fund Advisers” in the Proposed Rule Stage.