SEC Rule Changes in the Air for Private Equity

The Securities and Exchange Commission recently voted to propose new rules amending the Investment Advisers Act of 1940 to increase oversight on private equity fund activity, potentially bringing changes to decades-long practices that have garnered both scrutiny and returns in the $18 trillion industry.

The agency is seeking to increase overall transparency and tighten reporting and tracking requirements for private equity funds similar to companies on public exchanges. Under the new proposal, PE firms would provide quarterly investment disclosures outlining their fees and where returns are coming from. Currently, the SEC does not require such disclosures from the private equity industry, a substantial  difference for investors in private and public markets. 

New Regulations Risk Shutting Out The Little Guys

For smaller middle and LMM funds, these added reporting requirements could be onerous. Thousands of small, often family-owned businesses rely on the capital from these LMM PE firms to survive, thrive and create jobs.

Vice Chairman of the Riverside Company Pamela Hendrickson offers “I think it’s going to be harder for a firm that does not have the resources to track everything that has been requested. The proposed set of rules runs the risk of shutting out the little companies, especially those started recently by women and minorities. Only a firm with a lot of resources is going to be able to do the tracking and it’s hard to see how that tracking improves returns or creates jobs.”

Hendrickson refers to the 2021 Fairview Capital survey which found that women and minority-owned firms grew by over 25% over the year prior. The firm observed a record 280 women and minority-owned firms in market raising capital during the year, but from 234 firms in 2020. Women and minority-owned firms also targeted 6% of the capital estimated to be raised by the private equity industry in 2021, up from 4% in 2020.

As Hendrickson mentioned, more stringent regulations can disproportionately impact smaller private equity firms who are just getting started. Increased transparency of costs and fees requires more staff and accounting software with the obvious potential to increase costs to both the PE firms and government agencies that will need to execute the oversight. 

Added Regulations Might Not Be Necessary

Multiple sources emphasize that buyers and sellers in the private equity space are already acutely aware of what they are buying and selling – so who will benefit from additional reporting requirements?

As SEC Commissioner Hester Peirc, (the lone vote against the proposal) stated, investors in private funds “are able to fend for themselves.”

Conversely, “Private fund advisers, through the funds they manage, touch so much of our economy. Thus, it’s worth asking whether we can promote more efficiency, competition, and transparency in this field,” said SEC Chair Gary Gensler. “I support this proposal because, if adopted, it would help investors in private funds on the one hand, and companies raising capital from these funds on the other.”

The Red Tape Catch-22

While increased transparency aims to limit monopoly and oligarch-ish behavior in the private markets, the path to get there may end up sustainable only by large and established firms. Additionally, and not often mentioned in the on-going debate, taxpayer money will be used to pay for these new rules. You have to ask, does the cost and drag on returns outweigh the benefit, especially for small and less established firms who are just starting to build a reputation and return track-record? 

The elimination of indemnification is one of the proposed changes that concerns PE veterans. As it stands, private equity firm contracts allow PE firms to absolve themselves of legal responsibility for compensation or loss in the event an investor is dissatisfied. In short, since PE players are both typically professional investors, this clause means that both parties know what they are getting into beforehand and accept the inherent and implied risks with a particular deal. Could this indemnification lead to a wider pool of investors in private equity?

Long-standing practices have delivered big for pensioners, despite the lack of indemnification. A study done in 2021 by the American Investment Council found that in 2020, private equity investments delivered a median annualized return of 12.3 percent over a 10-year period for the 85 percent of public pension funds across America that partner with private equity.

So will new SEC rules really increase efficiency, transparency and competition, or be another cost layer that falls disproportionately on smaller, newer funds, many of which help small, local businesses thrive throughout the country? Stay tuned.