SEC Adopts New Private Equity Regulations
The U.S. Securities and Exchange Commission (SEC) officially issued new rules on August 23, 2023, referred to as Final Rules, to restructure the regulatory environment for institutional investors and private fund advisors. Although these regulations are less in scope than those proposed in early 2022, they still significantly affect the private equity sector.
By doing so, they highlight the industry’s dedication to enhancing investor safety, openness, and money flow. The private equity sector is undergoing a significant shift despite long-standing issues with transparency and conflicts of interest.
So, what about compliance with new SEC rules in private equity? There will be more openness and safety for investors due to these new rules, changing how private fund advisors communicate with them and provide critical information. But there’s more to it. This article will explore all of it, including how to adapt to recent SEC regulations in private equity and its compliance issues.
SEC and private equity regulations
The SEC proposed new rules for regulating private funds under the Investment Advisers Act 1940 on February 9, 2022. Private funds are investment companies that don’t solicit investments from the general public and meet the exemptions of the Investment Company Act of 1940.
On August 23, 2023, the SEC adopted an amended version of the rules on a 3-2 party-line vote. Under the final regulations, private funds will now be subject to six additional requirements that other investment advisers will not. The new SEC regulations for private equity firms and various financial entities hold substantial significance. These regulations provide a framework that fosters investor confidence and market stability. Private equity firms, mainly, are subject to SEC oversight due to their role in managing investments on behalf of institutional and accredited investors. This oversight helps safeguard the interests of these investors.
To understand the impact of SEC regulations on private equity firms, we must first know how private equity firms operate.
Understand private equity
Private equity (PE) means putting money into businesses, not for sale on a public market. Private markets handled over $11.7 trillion of assets in 2022. Private equity businesses seek ways to generate more profits than in the public stock markets. However, there can be certain aspects of the sector that you need to be aware of.
How does private equity work in the financial ecosystem?
Private equity, a kind of investment capital, originates from corporations that buy into or take over public companies to make them private again and delist them from stock markets. High-net-worth individuals (HNWI) who are looking to make a profit on a massive scale are another potential source of private equity.
Large private equity companies backed by accredited individuals and institutional investors like pension funds make up the private equity business. Private equity regulations require direct investment to influence or control a company’s activities. Therefore, investors with huge funds dominate the business.
New regulations adopted by the SEC for fund advisors
The SEC implemented three new rules: the “Adviser-led Secondaries Rule” the “Private Fund Audit Rule” and the “Quarterly Statement Rule” which are only applicable to advisors registered with the SEC. Additionally, the Commission approved the suggested changes to the Advisers Act Compliance Rule. Let’s break them down here for your understanding.
| Adopted Rule | Date Of Compliance |
|---|---|
| Private Fund Audits | 18 months |
| Restricted Activities | 18 Months( Registered less than.1.5 B AUM in private class assets) 12 months(Registered at least .1.5 B AUM in private class assets ) |
| Quarterly Statements | 18 months |
| Adviser-led secondaries | 18 Months( Registered less than.1.5 B AUM in private class assets) 12 months(Registered at least .1.5 B AUM in private class assets ) |
| Preferential Treatments | 18 Months( Registered less than.1.5 B AUM in private class assets) 12 months(Registered at least .1.5 B AUM in private class assets ) |
| Compliance Rule | 60 Days |
Quarterly Statement Rule
The Quarterly Statement Rule aims to increase the openness of private fund investments. It mandates quarterly reporting to investors by SEC-registered private fund advisors. These disclosures intend to illuminate certain elements, such as fees, performance, and possible conflicts of interest.
The Regulation- It is up to private fund managers to make these statements for the funds they are in charge of unless someone else has already done so. The quarterly statement must include specifics about how the fund is doing, information about fees and costs, and payments made to the manager and other people connected to the fund.
Key Disclosures- Statements must reflect the fund’s status relative to “capital call lines”. In addition, companies must clearly explain the methodology behind deducting fees and expenditures. There should be a list of all the relevant official papers about the fund.
New Timelines:
Under the old private equity regulation, quarterly statements were due 45 days following the quarter. The new regulation modifies this for several categories of investments:
- Fund statements for a fund of funds are due 75 days after the end of the first three quarters of the fiscal year and 120 days after the end of the year.
- Funds that don’t invest in other funds must send out annual statements by 90 days after the end of the year and quarterly statements by 45 days after the end of each quarter.
- The SEC also amended Rule 204-2 to reflect this new regulation. It is now mandatory for advisors to maintain documents relating to distributing these quarterly disclosures.
Private Fund Audit Rule
The Private Fund Audit Rule gives SEC-registered private fund advisers an independent annual financial audit for each fund they oversee. This financial audit must follow specific rules from the Advisers Act custody rule.
The audit’s results must be shared with current investors within 120 days after the fund’s year-end (or 180 days if it’s a fund that invests in other funds). This rule is here to stop any wrongdoing with money and make sure advisers value things correctly.
This rule is now more in line with the custody rule, unlike the original idea that had more audit rules. Also, it doesn’t mandate auditors to tell the Commission about specific problems they find during audits.
Adviser-led Secondaries Rule
The SEC has approved changes to the Adviser-Led Secondaries Rule. This rule aims to prevent fraud and ensure that assets are valued correctly. Now, SEC-registered advisers leading transactions must get a fairness or valuation opinion from an outside expert instead of just a fairness opinion.
They must also tell investors about important business relationships between them and the expert. This information must be shared with investors before they make decisions, not just before closing the deal. Tender offers are not part of this rule. The goal is to make the financial world fair and transparent.
Adoption of the Proposed Amendments to the Advisers Act Compliance Rule:
The Commission voted to approve changes to the Advisers Act compliance rule. Now, all SEC-registered advisers must write their annual review of their compliance policies and how well they work. These changes are the same as the one suggested in February 2022.
Restricted Activities Rule
The new private equity regulation prohibits Private fund advisers from engaging in certain activities without specific requirements. The requirements are:
- Charging or allocating fees or expenses associated with investigations of the adviser or its related individuals is off-limits. This restriction applies, regardless of disclosures or consents, especially if the investigation leads to a court or government authority imposing penalties for violating the Investment Advisers Act of 1940.
- They cannot pass on regulatory, examination, or compliance fees and expenses of the adviser or related individuals to the private fund.
- Prohibition of reducing the carried interest clawback by actual, potential, or hypothetical taxes linked to the adviser, related individuals, or their owners or interest holders.
- Prohibition of charging fees and expenses related to a portfolio investment on a non-pro-rata basis unless deemed fair and equitable. Advisers must provide written notice of the non-pro rata charge or allocation and explain its fairness.
- Restriction of borrowing money, securities, or other assets from a private fund client or receiving a loan or credit extension from them is restricted.
| Adopted Rule | SEC Adopted Rule Section Number |
|---|---|
| Private Fund Audits | 206(4)-10 |
| Restricted Activities | 211(h)(2)-1 |
| Quarterly Statements | 221(h)(1)-2 |
| Adviser-led secondaries | 211(h)(2)-2 |
| Preferential Treatments | 211(h)(2)-3 |
| Compliance Rule | 206(4)-7(b) |
Preferential Treatment Rule
The recent Preferential Treatment Rule has garnered substantial attention. This rule prohibits private fund advisers from providing specific investors with favorable terms regarding economics, redemptions, and portfolio information before meeting specific disclosure requirements.
- Prohibited Economic Terms- Concerning economic terms, private fund advisers must provide advance written notice to potential investors and written information to existing investors when offering material preferential terms. These material terms encompass the cost of investing, liquidity rights, fee concessions, and co-investment rights. Advisers must also disclose all preferential treatment to existing investors annually.
- Prohibited Redemptions- Regarding redemptions, advisers cannot grant certain investors preferential redemption rights if it would negatively impact other investors. However, exceptions apply when laws, private equity regulations, or orders mandate redemption rights.
- Prohibited Transparency- Regarding portfolio information, advisers cannot provide certain investors details about the fund’s holdings or exposures if it negatively affects other investors. They can only do so if they simultaneously offer the same information to all existing investors.
These rules apply to all private fund advisers, and larger advisers have 12 months to comply, while smaller ones have an 18-month transition period. Despite the SEC’s disclaimer, these rules may have implications for using side letters.
| Adopted Rule | SEC REGISTERED | NOT REGISTERED |
|---|---|---|
| Private Fund Audits | Yes | No |
| Restricted Activities | Yes | yes |
| Quarterly Statements | Yes | No |
| Adviser-led secondaries | Yes | No |
| Preferential Treatments | Yes | yes |
| Compliance Rule | Yes | No |
Other things to Note in SEC regulations for fund advisors
There are a few other things to be aware of when it comes to the new SEC regulations for private equity. Let’s look at them in this section.
Transition Periods and Compliance Date
The SEC made some changes in the transition periods for different rules. They gave an 18-month transition period for the Quarterly Statement and Private Fund Audit Rule. For the Adviser-led Secondaries Rule, the Restrictive Activities Rule, and the Preferential Treatment Rule, the compliance dates are as follows:
- If advisers manage $1.5 billion or more in private fund assets, they have a one-year transition period.
- If advisers manage less than $1.5 billion in private fund assets, they have an 18-month transition period.
Advisers must follow the amended Advisers Act compliance rule (Rule 206(4)-7) 60 days after publication in the Federal Register.
Limited Grandfather Status for Private Fund Clients Existing as of Adviser’s Compliance Date
For existing private fund customers, the final Rules contain a provision termed “legacy” or grandfathering status, which applies to redemption, information, and components of the Preferential Treatment Rule and the Restricted Activities Rule. They need investor agreement but are exempt from the general requirements of those rules.
Existing private funds are exempt from the Preferential Treatment and Restrictive Activities Rule’s basic requirements but are subject to disclosure provisions. After the compliance date, all of the private funds under the adviser’s management must comply with the remaining provisions of the private equity regulations.
This legacy status is applicable for governing documents created before the adviser’s compliance date, such as side letters, subscription agreements, and limited partnership agreements.
Impact of SEC new regulations on private equity firms and investors
- More stringent compliance standards, particularly driven by SEC regulations, will escalate operational and administrative expenses for private equity firms.
- To align with SEC’s private equity regulations, firms need to improve their reporting systems, focusing on improving transparency and record-keeping practices.
- The new regulatory landscape demands greater openness in all facets of business operations, compelling private equity firms to revamp their reporting mechanisms. This includes detailed disclosures of fees and costs, and addressing potential biases.
- Certain customary practices, such as preferential treatment or specific fee arrangements, may face restrictions under the new regulations. Private equity firms must reassess and potentially reshape their existing operating structures to maintain compliance.
- To adhere to the evolving regulatory landscape, private equity companies need to reconsider their current operating structures. This involves a comprehensive review and potential restructuring to ensure continued compliance and avoid regulatory pitfalls.
How to adapt to recent SEC regulations in private equity
The new regulations necessitate that private equity companies evaluate and update their fund documentation, subscription agreements, and disclosure materials.
Companies owe it to their investors to keep them apprised of any changes to their operations, the fund’s performance, or fees due to new legislation.
Businesses need to adjust their operating and accounting systems to meet the requirements of the new private equity regulations, such as providing consistent performance reporting. Working with legal and compliance professionals will be essential to navigate the regulatory environment successfully.
Manage Your Company’s Equity Hassle-Free With Eqvista!
Companies must immediately adjust their practices to meet the requirements of the new SEC private equity regulations. Eqvista provides a full suite of services for companies needing effective equity management solutions. Eqvista’s high-end software for managing equity, cap tables, and equity transactions helps businesses streamline these processes.
Our user-friendly features and emphasis on compliance make it possible for organizations to handle the complexity of equity administration with relative simplicity, resulting in records that are accurate, transparent, and under the relevant legislation. We understand your concerns about the complexity of our service. So, feel free to use our 20-minute free tutorial to familiarize yourself with the Eqvista platform’s capabilities.
