Coming just days after a US Appeals Court vacated the Securities and Exchange Commission’s (SEC) latest rulemaking on private funds, a joint JTC and K&L Gates roundtable discussion explored how regulation is shaping the $26 trillion alternatives industry.
Jeff Drinkwater, Senior Director of Institutional Client Services at JTC, kicked off the discussion by reminding the group of remarks made by SEC Chair, Gary Gensler, in 2021. When introducing the proposed Private Fund Adviser Rules (PFAR), Gensler was keen to emphasize the size of the industry, but more importantly, who stands on either side of it, with many LPs representing day to day individuals through retirement plans, or endowments. He commented that “it’s time we take stock of the rapid growth and changes in this field, as well as the decade of learning, and bring more sunshine and competition to the private funds space.”
A decade of learning
Sparked initially by the 2008 financial crisis, regulation of private funds in the US has increased exponentially over the last 15 years.
Under the Dodd-Frank Act which was enacted in 2010, private funds are required to submit a Form PF (Private Fund) to the SEC, an exhaustive report designed to help the regulator spot potential frauds and systemic risks. The information gathered through Form PF is the source of the ‘decade of learning’ referenced to by Gensler.
The Form PF provisions were subsequently updated in 2023 so that large hedge funds had to disclose so-called triggering events (i.e. extraordinary investment losses, margin events, termination of prime broker relationships) within 72 hours of them happening, while private equity firms had to do the same (i.e. if a GP is removed, fund termination events, etc), albeit on a quarterly basis.[1]
“The sheer volume of the rules impacting the private funds space nowadays is probably on a par with what mutual funds were dealing with 20 years ago,” said Lance Dial, Partner at K&L Gates.
A step too far
The SEC tried to take private fund regulation a step further with the recent PFAR. However, the industry was given a partial reprieve as the proposals – which would have obliged private funds to provide fee and expense disclosures to investors on a quarterly basis, while also banning them from offering preferential redemption terms to certain clients – were vacated by the Fifth Circuit.
This decision came after a successful litigation was brought against the SEC by industry groups, who argued the regulator had overstepped its statutory authority and that the rules were not necessary for sophisticated investors, who make up the bulk of private fund assets.[2]
Despite the court finding in favour of the industry, experts at the JTC and K&L Gates roundtable said the SEC’s proposals will result in managers seeing heightened transparency demands from investors. “While the rules have been vacated, the SEC has moved the needle on disclosure and on business practices,” said Pamela Grossetti, Partner at K&L Gates.
Michael Silvia, a Partner at accounting and advisory firm Marcum LLP, echoed this and said, “due to heightened transparency, many funds will need to maintain best practices, as the SEC will continue their exams with a focus on elements from the act that was not passed.”
Even with PFAR vacated, in today’s challenging capital raising environment, private funds may nonetheless push back less against client requests for more information, especially on sensitive matters like fees and expenses, irrespective of the court’s verdict.
As market standards evolve, so too will managers, even if it is not required of them by regulators.
Jamie Peterson, a Director at Iron Road Partners, argued that “I think it would be a mistake for us to associate the PFAR with the fall of transparency in the space. There are several significant initiatives already in place that relate to transparency.”
New rules, new costs
With regulations coming in thick and fast, the costs of running a private fund are getting higher.
“Compliance obligations are going up, and revenues are going down. Previously, it was a rule of thumb that a mutual fund needed $100 million to break even. Nowadays, a private fund often needs at least $100 million to break even,” said Dial.
“The SEC are also often criticized for underestimating the cost to the industry to implement their proposed rules,” added Drinkwater.
As the barriers to entry get higher, the industry is becoming increasingly concentrated, with the bulk of institutional money now going into just a handful of large managers. In the first three quarters of 2023, private equity attracted $227.05 billion, of which 40% went to the top 15 funds.[3]
The SEC is not blind to the challenges facing small and mid-sized managers, and already runs a number of working groups dedicated to small private funds. “The SEC wants to reach out to these managers, but small and mid-sized advisers do not have the resources to spend lots of time engaging with the SEC. It is a bit of a catch-22,” continued Dial.
New risk flashpoints emerge
During the roundtable, experts touched upon some of the main risks facing private funds, and whether these will invite future regulatory scrutiny.
- Private equity faces a liquidity conundrum
“A lot of people right now are saying the biggest risk in private markets, namely private equity, is the lack of liquidity within the asset class,” said Drinkwater.
This comes as successive interest rate shocks have caused exits to dry-up, with GPs currently sitting on $3.2 trillion of unsold assets, a situation which is impeding distributions to LPs, and ultimately hampering fundraising, particularly among small and mid-sized advisers, according to a report by Bain & Co.[4]
- A shadow banking system emerges
As risk-weighted capital requirements increase, banks are scaling back their loan books, which is creating opportunities for private funds, but also potential risks.
A number of private funds have launched private credit or direct lending strategies which provide financing to companies, filling the void left by banks. The asset class has enjoyed staggering growth, with a report by the International Monetary Fund (IMF) estimating the private credit market to be worth around $2.1 trillion in 2023, putting it on a par size-wise with that of syndicated loans and high-yield bonds.[5]
However, this is leading to intense debate about the systemic risks posed by non-bank lenders, especially those private credit funds which provided financing to riskier corporates when interest rates were low or at zero. Amid today’s current high-rate environment, there are mounting fears that the private credit model could be in for some tougher times ahead.
If concerns about the systemic risk, real or otherwise, posed by non-bank financial institutions such as private credit continue to grow, Dial warned regulators may be forced to intervene.
- Tokenization – a new risk for regulators to think about
Tokenization, namely the digital representation of an asset (including a fund) in token form on a Blockchain, has created a buzz in private fund circles.
As tokenization allows for fractionalization to take place, assets can be broken down into smaller units or digital tokens, meaning they are less expensive for people to buy. Through fractionalization, the logic goes that more people – including retail investors – will be able to gain exposure to assets that were previously out of bounds for them, such as private funds.
One study by Boston Consulting Group predicts tokenization of private markets could reach $16 trillion by 2030[6], although other forecasts are much less bullish.
However, Rick Lake, Lecturer at Boston University’s Digital Business Institute and Founder of consultancy firm Narrative Alpha, said tokenization is not without its challenges. As more organizations look to tokenize illiquid assets, including private market funds, some experts are warning about the risks of liquidity mismatches occurring.
Should tokenization take off in private markets, regulation will not be far behind.
Nonetheless, regulating in an environment where there is rapid change and new asset classes constantly emerging is not always easy, a point made by Rahul Shukla, Managing Director at Kroll.
Making regulation work
In order to stop systemic risks from escalating and to safeguard investors’ interests, regulators need to be proactive and thoughtful in how they approach supervision. “A lot of the worst regulation out there has been reactive regulation. In contrast, the best and most measured regulations often come after the authorities have observed long-term trends,” said Dial.
If you’d like to discuss this article or the services JTC can provide to private funds, please get in touch with Jeff directly.
[1] Paul Weiss – May 16, 2023 – SEC adopts amendments to Form PF for private equity and hedge fund advisers
[2] Bloomberg – June 5, 2024 – SEC hedge fund fee disclosure rule struck down by US court
[3] Private Equity International – October 23, 2023 – Top 15 fundraises made up around 40% of capital raising total this year
[4] Bain & Co – Private Equity Outlook 2024: The liquidity imperative
[5] IMF – April 8, 2024 – Fast growing $2 trillion private credit market warrants closer watch
[6] Boston Consulting Group – Relevance of on-chain asset tokenisation in crypto-winter
