SEC’s ‘earth shattering’ proposals unravelled

The US regulator's definition of what an adviser-led transaction refers to is not clear in its recent proposals, according to law firm Morgan Lewis.

Recent proposals and commentary from the US Securities and Exchange Commission have lit private markets’ collective hair on fire.

Mechanisms that were once sacrosanct, such as the 2-and-20 fee model and charging fees on committed capital, are suddenly feeling the heat of SEC scrutiny. While the rules are far from final, they cut to the core of private equity by requiring enhanced disclosure or outright prohibition on certain practices.

Last week, law firm Morgan Lewis & Bockius hosted a webinar with partners Christine Lombardo, Courtney Nowell, Jedd Wider and Joseph Zargari to discuss the implications of the “earth shattering” proposals. The questions the SEC has raised “target and hit well-established industry terms and conditions that have been widely accepted for decades in the PE [and hedge fund] industry”, said Wider.

The prohibition of practices “opens a Pandora’s box either now or in the future” for additional activities to be added to that list, which is “a real paradigm shift” from permitting these activities so long as they are disclosed, Zargari added.

Here are three ramifications of the proposals that could affect longstanding practices for sponsors and investors.

GP-led deals

The SEC is concerned about conflicts of interest with regard to adviser-led transactions, according to Lombardo, but the instrument of its inquiry is flawed.

The proposed amendment to Form PF would require advisers to report GP-led transactions within one business day of execution.

That window is too tight and would likely distract from the work itself, especially in situations where interpretation is necessary to deem if a sponsor-led transaction has occurred, the partners agreed during the webinar.

Further, what an adviser-led transaction really means is not exactly clear as the rule is written, Lombardo added. Written to capture single assets and strip sales, the rule could conceivably extend to tenders, other transactions and even cases with single LPs selling.

This could still change. The SEC in its public comment asked whether monitoring these transactions is even necessary, said Lombardo. As a general matter, these types of transactions “aren’t inherently nefarious”, but rather are “designed to provide liquidity”.

There are further ramifications for the GP-led market, such as whether market-tested pricing warrants exclusion from mandated fairness opinions.

Preferential treatment

While it is generally understood that large LPs command the ability to negotiate favourable terms and economics from sponsors on areas such as fund fees and co-investments, the new proposals would require such benefits be disclosed to current and prospective investors. Further, if such activities were deemed harmful to existing investors, such practices could be prohibited altogether.

The gesture toward transparency made by these proposals is a “good development”, said Nowell, but prescribing which beneficial terms can be negotiated is “troubling, even as an investor”.

“If you have chosen strategically to place a large allocation with an investment manager, part of that decision has typically been because you’re able to negotiate commercially some economic inducements in exchange for doing so,” Nowell added.

If enacted as written, such rules could cause difficulties for LPs like CalPERS, that achieve their returns by seeking “cost-advantaged” opportunities in funds, co-investments and separately managed accounts.

“The idea that giving one investor preference may be detrimental to the other investors is subjective,” added Nowell, “and it’s a material change from the way sophisticated counterparties negotiate side letters”.

Asymmetric burden

One important nuance to these proposals is that they do not discriminate by firm size. As a result, the administrative and monetary burdens may not be shared equally by the market, were the proposals implemented as is.

Unlike PE behemoths with robust teams in place, “the burden of new reporting will disproportionately affect smaller managers who may not have the back office to absorb the new reporting obligations”, said Nowell.

However, managers of any size may find themselves in a better position than their LPs.

“You have to assume these expenses will be treated as fund expenses,” added Nowell. Whether large or small, LPs may have to pay for the proposals that in theory are designed to protect them.

The distinction between what is defined as a fund cost versus an adviser cost “needs some focus, particularly as we’re adding additional fees and expenses here”, said Nowell.

This article first appeared in affiliate publication Private Equity International