The SEC’s New Rules on Private Equity: Investor Shield or Investment Stranglehold?

By: Robert Ayres

Private equity investing is one of the most popular asset classes in finance. As of 2022, $26 trillion worth of capital has been invested through private funds, which includes private equity, venture capital, and hedge funds.

         Historically, the sophisticated nature of private equity investors, often institutional investors and high net-worth individuals, allowed investors and funds to negotiate bespoke contractual arrangements that reflected the unique goals and needs of the individual investor. However, in the last decade, as private equity investing has become an increasingly attractive investment class, the number of private investors seeking out private equity funds has exploded. Due to the nature of these private investors, who are often institutional investors, such as pension funds, endowments, foundations, and other retirement plans, the number of individuals who have indirect exposure to private equity investing has greatly expanded. With the rapid growth and importance of private funds, regulators have grown increasingly concerned about investor rights and protection in private equity funds.

         Private equity funds are regulated primarily by the Investment Advisers Act of 1940 (“Advisers Act”), as amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), and the Investment Company Act of 1940 (“Investment Company Act”). Through these statutes, private funds and their advisers are required to register with the U.S. Securities and Exchange Commission (SEC), subject to certain, widely-used exemptions. Particularly relevant in today’s private equity universe, private funds that issue public offerings must register with the SEC pursuant to the Securities Act of 1933. However, with the substantial growth of private equity investing and increased public exposure, regulators, politicians, and the public are demanding reform of private fund regulations. Many of these parties' concerns focus on the potential for private fund advisers to treat investors differently by using various disclosure methods and levels of transparency. In January 2022, the SEC voted to propose amendments to “bolster the Commission’s regulatory oversight of private fund advisers and its investor protection efforts in light of the growth of the private fund industry.”

         Following a lengthy review process, the SEC issued new rules and amendments in August 2023 “to enhance the regulation of private fund advisers and update the existing compliance rule[s] that appl[y] to all investment advisers.” The new 2023 rules affect three classes of investment advisers including SEC-registered private fund advisers, private fund advisers in general, and SEC-registered investment advisers. The new rules require all SEC-registered private fund advisers to:

·      “Provide investors with quarterly statements detailing information regarding private fund performance, fees, and expenses;

·      Obtain an annual audit for each private fund; and

·      Obtain a fairness opinion or valuation opinion in connection with an adviser-led secondary transaction.”

For all private fund advisers, the new rules:

·      “Prohibit engaging in certain activities and practices that are contrary to the public interest and the protection of investors unless they provide certain disclosures to investors, and in some cases, receive investor consent; and

·      Prohibit providing certain types of preferential treatment that have a material negative effect on other investors and prohibit other types of preferential treatment unless disclosed to current and prospective investors.”

         Additionally, the new rules and rule amendments will require all registered investment advisers, including those who do not advise private funds, to annually disclose their compliance policies and procedures in accordance with the new rules. The SEC estimated that the new requirements will cost the private equity industry over $1 billion annually in compliance costs.

         In response to the SEC’s new rules and regulations, the National Association of Private Fund Managers and a number of similar interest groups filed a lawsuit in the United States Court of Appeals for the Fifth Circuit, alleging that the SEC “overstepped its statutory authority and core legislative mandate… harm[ing] investors, fund managers, and markets by increasing costs, undermining competition, and reducing investment opportunities for pensions, foundations, and endowments.” These groups argue that private equity funds are already sufficiently regulated under the Advisers Act and Investment Company Act, that the sophisticated nature of private fund investors enables them to sufficiently protect themselves, and that the new rules will significantly hamper the many unique benefits investors seek in private equity.

         The outcome of this case will have a significant impact on the SEC’s ability to regulate the relationship between private funds and their clients. Should the SEC’s new rules be upheld, this decision will expand the regulatory power of the SEC to intervene in private investment contracts and to enforce accountability schemes deemed necessary by the SEC for private funds. Alternatively, if the Fifth Circuit decides to overrule the SEC’s new rules, such a ruling would likely mark the outer-limit of the SEC’s abilities to regulate private investment agreements and private fund adviser disclosures.

         Both sides offer compelling legal arguments for their positions, however, it is unlikely that the SEC has the statutory authority to impose these new rules on private funds for two reasons. First, the SEC’s ability to regulate contractual arrangements between private funds and their investors is less convincing due to the new rules’ basis, which relies on a section of the Dodd-Frank Act that concerns retail investors. As described in the petitioner’s brief, the SEC relies on provisions of the Dodd-Frank Act that regulate an adviser’s relationship with “retail investors” and not the sophisticated, private parties that invest in private funds. Second, while the ability of the SEC to impose the new rules may have greater legal support in the general anti-fraud provisions of the Advisers Act, the SEC’s new rules appear too broad and insufficiently designed to prevent fraud within the private funds industry. Ultimately, these regulations will likely have a negative impact on the private funds industry and will disincentivize investment in one of the largest asset classes on the market.