The Securities and Exchange Commission (SEC) has approved new rules that will usher in sweeping changes for how private equity and hedge funds operate. One substantial rule change prohibits private fund managers from providing preferential treatment to Limited Partner (LP) investors involved in the funds. The new rules also require private funds to issue quarterly fee and performance reports, and to disclose certain fee structures, while barring some investors from preferential treatment over redemptions and portfolio exposure. In addition, the rules also require funds to perform annual audits.
What Do the New Rules Mean for Investors?
The rules affect investors who meet specific criteria concerning substantial assets that qualifies them to invest in private security offerings such as private placements and private capital raises.
As an investment banker who has managed private equity and debt raises for numerous companies over the past 23 years, I am happy to see the SEC make these changes. That’s because these changes will result in increased transparency, ultimately creating more competition among funds and greater efficiency in the private funds market. In some ways, private debt and equity funds have operated under a legal veil of secrecy that has not required General Partners (GPs) to regularly report fund performance or fees, so the new rules will help make certain investments fairer across the board.
While some of these rules go into effect this fall, others will be phased in, depending on the size of the fund, and as new agreements are executed, so the industry will not have to rewrite all existing investment contracts.
What Exactly is Preferential Treatment?
“Preferential treatment” usually comes from the GP in the form of side letters—peripheral agreements between private equity funds and their investors—offering certain incentives to select LPs.
One of the main “sticking points” of side letters has been that the instruments have included early exit terms, among other considerations, that can have a negative effect on other LPs by diluting their shares. The new rules still allow GPs to exercise preferential treatment via side letters; however, in those cases, they must fully disclose the terms of the side letter, and in some cases, those terms must apply to all investors who have purchased fund shares.
Similarly, GPs will be prohibited from offering certain LPs preferential treatment regarding information about portfolio holdings and exposure, without offering the same information to all LPs in the fund.
Required Reporting of Fund Fees and Performance
Another significant change to the rules requires private funds to produce quarterly financial statements for investors, along with fairness (valuation) opinions, on GP secondary transactions. Furthering transparency, GPs may continue to charge LPs fees related to investigations and regulatory expenses but only if they obtain consent from each investor in their fund and get the approval of a majority of investors in any given fund.
The Bottom Line
Once these new rules are implemented across the investment community, they will no doubt make the investment landscape fairer for investors in the private equity and debt marketplace. Transparency yields a fairer investment atmosphere for all. But as with all new rules – we shall see!