Private funds seek to draw a line in the sand

October 4, 2023

David Prosser

Financial Journalist

The private funds industry’s legal challenge to new reforms from the SEC is part of a larger argument about the future of US regulation.

Executives at the Securities and Exchange Commission (SEC) had hoped to avoid a confrontation with private funds over regulation of the sector. They have been disappointed. The new rules, announced in August, do not go as far as the SEC had originally intended. But despite this row-back, the regulator found itself hit with a law suit within days of unveiling the updated regime.

At first sight, the Private Finance Adviser Rules appear relatively modest. They impose new requirements on reporting and disclosure, such as a duty for funds to provide investors with statements on performance, fees and expenses. They also restrict funds’ abilities to engage in practices such as offering some investors enhanced redemption rights or preferential rates on fees; funds will only be allowed to behave in these ways if they make appropriate disclosures or, in some instances, seek explicit consent from investors.

The SEC argues that this regulation does little more than bring private funds into closer alignment with the rulebook that governs public funds run by banking groups in the US. The regulator also points out that it has made significant concessions following feedback from the private funds industry; the draft rules had envisaged an outright ban on many practices that will now be allowed if investors are told about them or give their permission.

Spoiling for a fight

Nevertheless, many in the private fund sector think the reforms represent a regulatory over-reach. On 1 September, six trade associations asked a Texas-based federal appeals court to overturn the new rules. They argue that the cost and restrictive nature of the regulation will stymie growth in the sector, hitting jobs and limiting the amount of capital available to the broader economy.

Privately, private equity and hedge funds also express concern that this regulation will prove to be the thin end of the wedge. The SEC has become increasingly interventionist, they argue, and this regulation is likely to prove to be merely an opening skirmish in a more aggressive incursion into their industry.

For interested parties and onlookers, there are now two obvious questions. First, are the SEC’s new rules proportionate and reasonable? And second, does the SEC have the statutory powers to impose this new regime (if no, the answer to the first question is rendered moot)?

The debate is far from clear cut. The private funds industry rightly points out that its investor base is professional, well-resourced and well-advised. Investors such as family offices and pension funds have the experience and expertise to manage their relationships with private funds; they understand the pros and cons of different approaches, and the need to scrutinise cost and performance. For all these reasons, they do not need to be protected by a regulator in the same way as, say, retail investors, who may be much vulnerable to exploitation.

US regulation – in line with regimes in other mature financial services markets – has long recognised this distinction. The rules governing the private funds sector have always been looser than those surrounding private funds; the goal has been to encourage market growth through deregulation.

The counter argument is that these are different times. For one thing, the private funds sector has grown enormously. The SEC says there are now more than 47,000 funds worth more than $14 trillion registered with it; that’s an increase from only 20,600 funds worth $5.3 trillion a decade ago. An industry of this scale must be held accountable, the regulator and its supporters argue.

A second point is that the assets managed by the industry do, ultimately, come from retail investors who are protected elsewhere. Private fund customers such as pension funds, after all, are simply stewards of retirement savers’ money; in which case, it might be argued that these savers are entitled to equivalent levels of regulatory protection however they choose to allocate their money.

One battle in a bigger war

The broader picture here is that the tensions between Wall Street and regulators have become increasingly political. Democrat leaders, including Senator Elizabeth Warren, accuse the private funds sector of abuses and opacity as part of their campaign for tougher regulation of the whole financial services sectors. Senior Republicans, including Senator Tim Scott, the ranking member on the Senate Banking Committee, are committed to pushing back.

All eyes, then, are on Texas’s US Court of Appeals for the Fifth Circuit, widely regarded as a conservative adjudicator. The private funds sector is hopeful of a good result from its legal challenge – they point to the decision of a federal appeals court in Washington DC in August, which was highly critical of another SEC initiative, the rejection of plans by asset management firm Grayscale to convert one of its products into an exchange-trade fund.

In Texas, however, more is at stake. If the SEC wins, it will be emboldened – further regulation may follow, perhaps this time without so much compromise. A victory for the six trade associations, by contrast, could check the regulator’s shift towards a more interventionist approach.

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