The SEC’s regulatory gambit: unpacking the compliance conundrum

SEC Chair Gary Gensler has a packed agenda. Beyond attempting to regulate cryptocurrency markets, ESG-focused fund and the ‘meme stock’ frenzy, Chair Gensler is taking aim at the private fund industry.  With a raft of passed and pending rules on disclosure, conflicts, recordkeeping, compliance and cybersecurity, private funds are scrambling to keep up.  Two new rules merit a closer look.

Private Fund Rule

Finalized in August 2023, the Private Fund rule imposes substantial costs on private fund advisers.  While some observers feel the SEC retreated from certain aggressive provisions, others have brought litigation alleging the Commission has gone too far.  As with other recent regulatory initiatives, clarity will emerge gradually over the 12–18-month compliance period.

The new rule will restrict advisers from entering special arrangements, or ‘side letters’, with investors.  Side letters have historically granted certain investors lower fees, greater liquidity and/or higher levels of transparency in return for large investments.  Under the new rule, if such preferential treatment negatively affects other investors, advisers must offer the preferential terms to all other investors without restriction, irrespective of their investment size or commitment period.

The Private Fund rule also requires that funds provide quarterly financial statements with detailed information on fees and expenses as well as standardized performance reporting. While annual audits have long been the norm due to the custody rule, quarterly financials are a major change. Detailed information about fees paid to the adviser and expenses charged to investors are also a departure from traditional practice.

Of particular interest is the requirement for a written annual compliance review. Previously, an annual review was required but there was no specific requirement that it be in writing.  While most annual reviews were reduced to writing, this provision signals a desire on the part of the SEC to scrutinize written reviews during examinations of advisers.

Other stipulations include restrictions on adviser-led secondary offerings, a ban on passing certain expenses onto investors and greater disclosure about portfolio liquidity.

Marketing Rule

Implemented in November 2022, the Marketing Rule is the first overhaul of adverting and solicitation regulations pertaining to the investment management industry since 1969.  The SEC’s first enforcement action under this rule sends a clear message: the commission means business.

The rule supersedes and amplifies the old “Cash Solicitation” rule, which did not cover Third Party Marketers (TPMs) for private funds. TPMS are now required to disclose any compensation they will receive and any conflicts of interest, such as affiliations with the fund manager or investments in the fund.  Certain disclosures must be made at the time of solicitation, even if the solicitation is made verbally.

The compliance burden this rule adds is significant. For instance, if a TPM promoting a hedge fund receives 20 per cent of fees generated from introduced investors, this compensation arrangement, along with any other conflicts of interest, must be disclosed. Fund managers must also demonstrate a "reasonable belief" that TPMs comply with disclosure requirements, which could involve call recordings or other record-keeping measures.

The rule also brings a significant change in performance reporting. It has long been an article of faith that private funds should report their performance net of fees. Private fund fees can be three, four or five per cent of assets, or even more. Reporting gross performance would give investors an unfair return expectation. The new rule codifies this prohibition and goes one step further. The SEC now says that ‘extracted performance’ must also be shown net of fees. The industry bristled at this provision and most maintained that attribution (by sector, strategy, or other subsets of a portfolio) was not extracted performance. Not so, said the SEC in a recently published FAQ. As to how to allocate fees and expenses, well, that’s up to each adviser to figure out.

Rob Schwartz serves on Fund Boards and valuation committees. He has over 30 years of experience working in law and compliance for broker/dealers and investment managers.