New SEC Rule Has Big Changes for Fund Managers and Investors

The SEC’s private fund advisor reforms were approved on a 3-2 vote, and while modified and weakened to some degree according to exports who have spoken with GlobeSt.com, they still are, as the Wall Street Journal put it, “the biggest regulatory challenge in more than a decade to firms such as Blackstone, Apollo Global Management and Citadel.” And to much smaller companies as well that are part of the estimated $25 trillion in gross assets being managed.

“Compared to the proposal, it’s been watered down to make it more acceptable, to reduce pushback,” says Ron Geffner, founding member of the executive committee at Sadis & Goldberg, as well as overseeing the financial service group and being a former SEC enforcement lawyer. “The three main things I think that will affect the industry are quarterly reporting, the preferential treatment rule, and the audit rule.”

The challenge for fund managers of the audit rule will be to reduce complexity. “All registered investment advisors are required to audit any private deals they manage,” Geffner says. The coming challenge is when within with special purpose vehicles that only invest in one asset. That could mean a lot of reporting. One approach, according to Geffner, would be to aggregate all the entities into an umbrella one and structure them as a portfolio, but then investors see all the assets “and have access to all the data that they historically didn’t have.”

The preferential treatment rule is a second challenge and goes into effect in 12 months for larger funds and 18 months for smaller ones. “They cannot give preferential treatment on redemptions if the redemptions will have a material negative effect on other investors,” says Geffner. “Basically, all the investors will get all favored nations status.”

There will likely be ways to work around it, maybe creating different funds for different classes of investment. Ironically, this could disadvantage smaller funds the most, making it harder for them to raise money from larger institutional sources, according to Genna Garver, a partner at Troutman Pepper. “A smaller manager may have had a shot because they were willing to cave on some of the terms to get the cash,” she tells GlobeSt.com. But if there is no advantage, it might be harder to attract the bigger investors, who could simply go with managers they already knew.

The biggest issue, according to Geffner, is all the additional reporting, which brings costs that will get passed down to the investors, and opens potentially embarrassing information, like compensation, where it is common, he says, for managers to control other business entities and have them do work for the fund, siphoning off additional pay.

Garver said that written annual reviews, which “no one is talking about because it applies to all registered advisors,” could prove a mine field. “You have to say everything you looked at and everything that was wrong and what you did to fix that,” she says. “From a risk perspective, that is a pretty risky new rule and it’s not getting enough attention.”