The majority of private equity fund managers already disclose enough financial information to their LPs on fees and performance, say critics of new SEC proposals. So, who benefits from a more transparent asset class?
With private assets under management at an all-time high and recent shocks such as the pandemic putting a spotlight on portfolio performance, regulators are pushing fund managers to increase the amount of financial information they are disclosing on their private equity investments.
In the US, the Securities and Exchange Commission (SEC) wants to increase the frequency and speed with which private equity funds report on Form PF – a disclosure document adopted as part of the regulatory overhaul post-financial crisis. It wants to spot potential flashpoints building up in the fast-growing private markets and potentially use this information to increase examinations and enforcement.
New proposals may require managers to disclose more information to their LP investors, and in different ways; information on fees and expenses, fund performance, changes to key personnel and strategy – in some cases reporting these changes within one business day. The SEC also wants to prevent or limit perceived preferential treatment of some LPs, for example on fees, but also in the GP-led secondary market where fairness opinions by independent third parties have been identified as a way to further protect LPs.
With the compliance deadline for the SEC’s new marketing rules due in November and other guidance globally calling for more disclosure from GPs, the burden on private equity fund managers is set to grow considerably in the long-term.
In the UK, the Financial Conduct Authority (FCA) is moving ahead with its adjustment of European Union (EU) regulations post-Brexit alongside implementation of its own sustainable investment requirements, while the EU pushes its own regulatory agenda with the reworking of the Alternative Investment Fund Managers Directive (AIFMD) and the second phase of its Sustainable Finance Disclosure Regulation (SFDR), the first of which came into effect last year (see page 9 in this report).
Slow and uneven
The impact of the increasing regulatory burden on GPs will be slow and uneven, say industry sources. For the vast majority, quarterly financial statements are already commonplace, followed by more detailed annual reports and investor meetings. Side-letters – while not standardised – are also frequently used to respond to individual LPs seeking specific financial information, many of which face their own burden of regulatory compliance.
In many cases, the disclosure of financial information is already comprehensive across the industry, say both GPs and LPs. In an industry survey, conducted in May by Private Equity Wire, only 36% of respondents said there needed to be stricter regulatory oversight of the private equity industry. Many more (46%) had concerns about greater regulatory scrutiny of their business. “When you’re not in these funds it’s very easy to point the finger and say how murky it looks,” says a large North American LP.
What is expected to change is the format and level of detail required in some of these disclosures, particularly in areas such as performance, remuneration and fees, where some GPs may eventually be judged differently by their investors. The way some fund managers present a fund’s IRRs has been criticised in the past, particularly where credit lines are being used in lieu of investor commitments. Changes to fund strategy and key personnel may also become more transparent. In a recent note to the industry, veteran investor and co-founder of Ardian Vincent Gombault wrote that the fast evolution of the private equity market has created instances where managers have deviated materially from their mandated investment strategy, for example with European buyout funds investing in North America.
“There have been times when changes in fund strategy have not been so clear,” agrees Claire Madden, managing partner at London-based investment manager Connection Capital, “but there is usually a rationale there somewhere. Given the recent fundraising environment, managers with a widening remit are probably worth keeping an eye on – if you’re a new investor in one of those that would worry me as the risks or illiquidity may be greater than presented.”
Still in their proposal stage, the SEC rules on increased disclosure could look very different in their final form, say lawyers in the industry. Their timeline for implementation could also be longer than expected, particularly if litigation is involved.
In Europe, where AIFMD II is considered more of an evolution than a change in mood, says Andrew Poole, director at governance, risk, and compliance advisory firm ACA Group, requirements for quarterly reporting to investors of direct and indirect fees and charges allocated to the fund or to any of its investments have also been identified, along with the disclosure of side-letters. However, lawyers say implementation may not happen until late 2024 or 2025.
In the US, there has been strong pushback from parts of the industry on the SEC proposals, and some support from LPs and pension funds.
Power grab
US-based private equity lobby group The American Investment Council wants the regulator to drop the proposed changes, describing them as intrusive and unnecessary. It believes the requirements could ultimately reduce returns for investors and limit their options for exit and liquidity in the GP-led secondary market. The Canadian Venture Capital and Private Equity Association has said the SEC proposals will negatively impact Canadian investors.
These objections have been echoed in the mainstream. An editorial in the Wall Street Journal recently described the SEC move as “an enormous power grab for an agency whose purpose is to protect mom-and-pop investors from fraud – not sophisticated investors from risks they willingly take”.
Of course, not all private equity investors are equally sophisticated – while many of the larger and more experienced institutional investors have their own internal systems and templates for assessing fund performance and costs, newer entrants to the asset class face more challenges in their back-office accounting. To what extent retail investors are protected is also on the mind of regulators.
With record levels of allocation to private equity globally, greater transparency on fees and performance could ultimately shift the balance of power from GP to LP.
“It has been a GP’s market over the past five years, where they have been free to negotiate their fee arrangements with different investors,” says Chris Good, investment management partner at law firm Macfarlanes in London. “But there’s all sorts of interesting tensions because you’ve got a lot of market power with popular GPs, who are thinking 10-15 years ahead that they are going to have to take more retail money and getting ready for that point in time.”
In the UK, recent policy has been focused on making investment in private markets easier for DC pensions which are typically used to passive tracker funds with very low fees, says Good’s colleague Lora Froud, investment management partner at Macfarlanes.
“I think there’ll be a lot of pressure on private equity managers to think about different fee models and lower fee models,” she says. “And the question, of course, is will the private managers want to play in that space given the fee sensitivities?”
Although there have been attempts to standardise disclosures on fees, such as ILPA’s fee reporting template, a lack of specificity in some areas has allowed private equity managers to disguise their costs relative to peers or the wider market. But if regulators enforce too much of a standardised approach to disclosure, they risk stifling innovation among LPs or service providers with access to this data.
Holy Grail
“Data is the key topic. Everybody’s looking to get a clean, central repository,” says Poole at ACA, “but it remains a Holy Grail. I think it is still developing. Everyone’s trying to kind of do something on it so it’s definitely a growth area. We wait to see if someone can unlock that code.”
For private equity houses with large compliance teams and above-average performance, an increase in regulatory burden may have a silver lining: keeping a lid on competition from new start-up managers worried about costs.
Responding to a question about increased regulation from the SEC on a fourth-quarter 2021 earnings call, KKR co-chief executive Scott Nuttall said: “I think the level of regulatory scrutiny of our space is probably a positive for larger players that are more institutionalised. And so, there’s aspects of how the regulatory environment is developed that I think the barriers to entry in our space have gone up, and that’s good for incumbent players.”
Global GPs with a European base or fund structure can benefit from marketing passport rights under AIFMD, allowing them to fundraise more freely across the region. MEPs are considering proposals to broaden the scope of the AIFMD marketing passport so that alternative funds can be passported across the EU, not just to professional investors, but also to high-net-worth individuals and family offices, says Froud. Those without these rights are going to face “some strategic decisions about how they run fundraising,” adds Good.
One private equity manager based in Europe believes the “first-movers” who have already embraced fuller disclosure on ESG performance are now best placed to handle an increase financial disclosure. Others may be less successful in handling the burden.
“PE managers are businesses at the end of the day and if [new regulations] makes it impossible to run their business, then smaller firms will be disadvantaged,” says Madden. “There needs to be recognition that there is a vibrant, smaller end of the market or that will just go. Look at what happened in wealth management, the financial advisory market consolidated and there were less bespoke options around as a result.” The real winners of a more transparent asset class could be service providers and fund administrators, say sources. “All this points to either bulking up the back-office or more outsourcing. For service providers this is their bread and butter,” says Simon Crown at Clifford Chance.
Poole agrees that outsourcing offerings such as ACA’s can absorb, automate, and streamline some of the more repetitive compliance checks but ultimately it comes down to how open and organised a GP might be. “We rely on the information that comes from the GPs. We don’t know what their performance is, we will rely on them who rely on the fund administrators and fund accountant so it becomes a circular conversation.” 
