Simon Guilbert, Audit Director at KPMG in the Crown Dependencies, examines some of the key takeaways around the Securities and Exchange Commission’s recent proposed rule changes for private fund advisers
In February, the Securities and Exchange Commission (SEC) proposed regulatory reforms that would have a major impact on private fund managers in the US.
The proposals represent the most extensive reforms since the passage of the Dodd-Frank Act of 2010 and target a sector that holds more than $18trn in gross assets.
The proposals in many cases apply not only to SEC-registered advisers, but also to US and non-US private fund advisers that rely on the SEC’s ‘exempt reporting adviser’ exemptions.
While managers in the UK may not be entirely familiar with the implications of the proposed regulatory reforms, close attention should be paid to the latest developments, which are designed to capture all fund fees and expenses.
Key points
If implemented, how will this influence the industry? KPMG in the Crown Dependencies has outlined the notable takeaways and how the changes would affect managers and investors. They would:
• Require private fund advisers registered with the SEC to provide investors with quarterly statements detailing information about private fund performance, fees and expenses.
• Require registered private fund advisers to obtain an annual audit for each private fund and cause the private fund’s auditor to notify the SEC upon certain events.
• Require registered private fund advisers, in connection with an adviser-led secondary transaction, to distribute to investors a fairness opinion and a written summary of certain material business relationships between the adviser and the opinion provider.
• Prohibit all private fund advisers, including those not registered, from engaging in certain activities and practices that are contrary to the public interest and the protection of investors.
• Prohibit all private fund advisers from providing certain types of preferential treatment that negatively affect other investors while prohibiting all other types of preferential treatment unless disclosed to current and prospective investors.
The extent to which the proposals would prohibit all private fund advisers is all-encompassing, from engaging in several activities, including seeking reimbursement, indemnification, exculpation or limitation of liability for certain activity, charging certain fees and expenses to a private fund or its portfolio investments.
They would also extend to fee charges or expenses related to a portfolio investment on a non-pro-rata basis and borrowing or receiving an extension of credit from a private fund client.
Knock-on costs
The SEC has positioned these reforms as protecting private fund investors. But the content has raised eyebrows in the industry.
If enacted, additional costs will be incurred by private fund advisers and their funds. The requirements for annual audits, quarterly statements and fairness opinions will necessitate the engagement of external providers, the costs of which will ultimately be borne by investors.
There are also likely to be shortfalls in many (notably smaller) private fund advisers’ internal reporting systems and processes that will require investment to remediate.
Furthermore, it is possible that the proposed reforms are misguided in seeking to protect private investors, because investors in private funds are typically sophisticated enough and sufficiently resourced to protect their own commercial interests.
Traditional sources of capital in private funds have the means and capability to perform extensive due diligence and negotiate terms with private fund advisers.
Additionally, these proposed rules may have an unintended adverse consequence of discouraging new private advisers, given the additional costs involved and limitations on offering preferential treatment to certain investors via confidential side-letters.
Why make the reforms
From the vantage point of the SEC, there are compelling reasons for reforms to be proposed to protect investors.
They will provide greater transparency and compel practices that do not incentivise advisers to place their interests ahead of their private funds.
In particular, the requirement for SEC-registered advisers to provide standardised reporting to investors detailing compensation, fees and expenses and so on, and mandating uniform definitions of performance metrics such as IRR (internal rate of return) and MOIC (multiple on invested capital), will likely be welcomed by existing and prospective investors.
In addition, annual audits will provide an important check on advisers’ valuations of private fund assets. These often form the basis for the calculation of adviser fees and can be highly subjective and prone to bias.
At the time of publication, the SEC was still in the process of considering public comments received on the proposals. Only time will tell whether these are the right proposals for the industry and if they will prove successful in striking a balance between protecting investors and imposing a regulatory burden on private advisers.
While the reforms are left hanging in the balance, KPMG in the Crown Dependencies is weighing up the proposals’ pros and cons and advising clients to get a transparent understanding of the proposed rules and the overall impact the changes will have on the industry.
KPMG wishes to provide investors with comfort by outlining a concise step forward for when the comment period ends and the rules are finalised.
Find out more
For further advice, contact Simon Guilbert. Email: sguilbert@kpmg.com
About KPMG
The KPMG firms in the Channel Islands and the Isle of Man have combined to create KPMG in the Crown Dependencies. This creates a professional services business of 460 people, locally owned and dedicated to serving the key industry sectors across the three islands. The KPMG name and logo are trademarks used under licence by the independent member firms of the KPMG global organisation.
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