Aug 23, 2023
A recent shift in SEC regulation promises to change how GPs raise money from LPs.
According to a recent PitchBook article, the SEC's recent decision marks a significant shift in the power dynamics between private investment fund managers and their limited partners (LPs). During a Wednesday open meeting, the SEC approved new rules and amendments to the Investment Advisers Act of 1940. While these rules are more flexible than the initial proposal from February 2022, they bring about important changes for private fund managers.
One of the key changes involves prohibiting preferential terms, which are often used as negotiation tactics between fund managers and investors. This move aims to ensure fairness and transparency in dealings between fund managers and LPs. Additionally, private funds will now be required to provide quarterly financial statements to investors, and GP-led secondary transactions will necessitate a fairness or valuation opinion.
Notably, the SEC decided to remove a contentious liability rule that would have held fund managers legally responsible for negligence, alleviating some potential legal burdens.
One of the new rules prevents fund managers from entering into preferential treatment agreements with LPs that could harm other investors materially. Such harm could include allowing an investor to exit a fund prematurely, potentially diluting the value of other investors' stakes. Similarly, if a fund manager provides preferential information to an investor who can then use that information to redeem investments ahead of others, it could negatively affect other LPs.
Preferential treatment often takes the form of side letters, which are peripheral agreements between private equity funds and their investors, offering specific incentives to LPs. However, interpreting which terms might have a material negative impact on other investors remains a challenge.
To provide some flexibility, the final rule allows GPs to offer preferential treatment to LPs through side letters, as long as the terms are disclosed and, in some cases, offered to all investors. Exceptions to the prohibition on certain preferential redemption rights are made when redemptions are required by law or regulation or when a GP extends the same redemption ability to all fund investors.
The commission also introduced a legacy provision, allowing existing funds to continue without renegotiating agreements with current investors, a relief for many in the industry.
The new rules also address the imbalance of power between LPs and GPs by offering greater transparency in negotiations. LPs will gain access to information about side-letter provisions, altering the dynamics for managers seeking capital in the private markets.
Despite the exceptions, the new rules regarding preferential treatment may pose challenges for investors, both in interpretation and application. Furthermore, private fund managers will now need to provide quarterly statements detailing the costs of investing in the fund and its performance, as well as an annual audit for each private fund under their management.
In the secondary market, fund managers involved in GP-led secondary transactions must obtain a fairness or valuation opinion from a third-party provider, aiming to address potential conflicts of interest.
While the initial proposal included prohibitions, the final rules offer a restricted list of activities, each with a disclosure-based exception. For example, private fund managers can charge LPs for fees related to investigation and regulatory expenses if they obtain consent from each investor and a majority interest of investors approve it. This narrowing of restrictions is seen as a positive development.
In conclusion, as reported in a recent PitchBook article, the SEC's new rules and amendments aim to bring greater transparency and fairness to the private investment fund industry, reshaping the dynamics between fund managers and their investors.