The Securities and Exchange Commission just proposed new rules to protect investors in private investment funds. The proposed rules would require private fund advisers to disclose certain information and avoid certain practices. But these retail-like protections for private fund investors seem inconsistent with the long-held belief that such investors can fend for themselves. The proposed rules also raise legitimate questions about the continued denial to retail investors of access to investments in private funds.
The capital markets blogosphere has already offered worthy summaries of the proposed rules, and my aim here is not to add to those. In brief, registered private fund advisers would need to provide investors with detailed quarterly information on fees, expenses and performance, obtain annual financial statement audits by a PCAOB-registered auditor and provide investors with an independent fairness opinion for any adviser-led secondary transaction. All private fund advisers would be prohibited from engaging in certain sales practices, conflicts of interest and compensation arrangements, including charging certain types of fees and expenses to a private fund or portfolio investment, allocating certain fees and expenses in a non-pro rata manner and providing certain types of preferential treatment.
The SEC does have authority to regulate advisers to private funds. Dodd-Frank requires that advisers to private funds register with the SEC, and that the SEC establish reporting and recordkeeping requirements for such advisers for investor protection and systemic risk purposes.
But why the need for retail-like protections? Most securities offerings by private funds are conducted under Rule 506(b), which for all practical purposes limits offerings under the Rule to accredited investors. And offerings conducted under Rule 506(c) by definition are limited solely to accredited investors. The entire rationale for the special status afforded to accredited investors is that these are persons who can fend for themselves. But being able to fend for themselves means they, alone or with the advice of lawyers and other advisers, know what questions to ask and what information to demand, and have the leverage to extract it from private fund managers. Having the ability to fend for themselves means they don’t need the retail-like type of protections the SEC is proposing here. The historical rationale for carving out a special category of persons that may invest in non-registered offerings is that such persons have the leverage to extract material information from the issuer and/or have the financial wherewithal to bear the risk of loss. But by imposing retail-like mandates on advisers to an asset class invested in only by accredited investors, the proposed rules would seem to contradict that rationale. Further, if the SEC will impose a whole new retail-like disclosure and practice regime on private fund advisers, what would be the continuing justification for the retail vs. accredited investor distinction? Shouldn’t the new retail-like mandates open the door to access to private fund investment by retail investors?
Commissioner Hester Peirce put it best in her statement on the SEC’s proposed private fund adviser rules:
“Today’s proposal represents a sea change. It embodies a belief that many sophisticated institutions and high net worth individuals are not competent or assertive enough to obtain and analyze the information they need to make good investment decisions or to structure appropriately their relationships with private funds. Therefore, the Commission judges it wise to divert resources from the protection of retail investors to safeguard these wealthy investors who are represented by sophisticated, experienced investment professionals. I disagree with both assessments; these well-heeled, well-represented investors are able to fend for themselves, and our resources are better spent on retail investor protection. Accordingly, I am voting no on today’s proposal.”
Commissioner Pierce makes a good point about diversion of scarce enforcement resources. As she later points out, the SEC has historically prioritized the protection of retail investors over those deemed able to protect themselves, even after Dodd-Frank. Adoption of these proposed rules will require a redeployment of resources away from retail investor protection in favor of protecting those with means and sophisticated counsel.