Private equity firms are facing increased disclosure requirements and new restrictions on giving certain investors special treatment. Are current market policies sufficient to limit exposure in this new environment?
The New Rules
On August 23, 2023, the United States Securities and Exchange Commission (“SEC”) adopted new rules and amendments governing the $27 trillion private funds sector. Among the new rules, private fund advisors registered with the SEC will be required to provide investors with quarterly statements detailing fund fees, expenses, and performance. The new rules will also require private fund advisors to obtain and distribute to investors an annual financial statement audit of each private fund it advises and a fairness opinion or valuation opinion in connection with any advisor-led secondary transaction. Finally, the rules will prohibit private fund advisors from providing investors with preferential treatment regarding redemptions and information via so-called side letters unless full disclosure of such arrangements is made to “all current and prospective investors”. The SEC has given advisors one year to adapt to the new requirements, while those managing less than $1.5 billion have been given 18 months.
Final rules more industry-friendly than anticipated
Private equity firms have fought proposed regulations for years arguing that increased regulations would reduce investment opportunities. These arguments have been moderately successful in achieving modifications to the initial proposal. The initial proposal prohibited fee charges for services that were never performed and restricted fund managers and advisors from limiting their own liability. Neither of these prohibitions appear in the final rules.
Private equity and hedge funds challenge new rules
Notwithstanding the apparent compromises noted above, on September 1, 2023, a cohort of groups representing private funds filed a lawsuit in the United States Court of Appeals for the Fifth Circuit challenging the SEC’s authority to adopt the new rules. A copy of the petition is available here. The suit alleges that the new rules would bar many of the bespoke contractual terms investors negotiate to meet their specific needs, would bar advisers from charging for certain expenses, and would impose unnecessary reporting requirements. The petitioners argue that the new rules violate the Administrative Procedure Act (5 U.S.C. § 706) insofar as they exceed the SEC’s statutory authority and were adopted without adhering to the proper notice-and-comment procedure. The SEC has vowed to vigorously defend the new rules in court. The Court has ordered the SEC to submit a copy of the administrative record, the paper trail that documents the basis for its decision, by October 11, 2023.
Impact on underwriters
The lengthy 660-page rules document will require extensive review for those in the industry. Nevertheless, at this preliminary stage, the impact on insurers may be significant. As a result of the new rules, investment advisors appear subject to greater risk and potential liabilities. For example, the new quarterly disclosure requirement may give rise to increased claims for breach of fiduciary duty or even fraud if those disclosures change from one period to the next. The prohibition against granting preferential treatment to certain investors may also provide an impetus for new claims. Litigation arising out of such claims will necessitate the retention of experts to opine on the question of whether the alleged misconduct has a “material, negative effect” on other investors. Retention of these experts will lead to increased average costs for dealing with inquiries.
Preparedness is key
Though the private equity landscape continues to develop, advance preparation remains the best course to prevent unnecessary exposure to alleged corporate malfeasance. Policy terms may need further consideration on scope of coverage in view of the possible increase of claims and with respect to conceivably greater and more frequent SEC oversight. Claims professionals need to be on the lookout for new claims brought under the rules once effective.
