In the wake of the great financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act represented a sea change to U.S. hedge fund advisors and private equity groups. In particular, the mandatory reporting of certain information under Form PF, which became effective from June 2012 onwards brought reporting obligations not seen before. Since then, private funds have largely escaped significant regulatory scrutiny.
However, the SEC is now on a path to increasing disclosure and general reporting volumes that apply to U.S. private funds and advisors. Its rule proposals and staff guidance include a raft of additional compliance requirements including reporting of large swap positions, cybersecurity incidences, improper limitation of liability through hedge clauses, new audit requirements and a proposed amendment to applicable beneficial ownership reporting rules. In addition to these proposals, the SEC also issued a Risk Alert flagging many “common deficiencies” noted from its supervisory activities focusing on U.S. private funds and advisors. The alert highlighted a raft of areas for concern, including the following:
- conflicts of interest
- fees and expenses
- insufficient policies and procedures relating to material nonpublic (“insider”) information
- conduct inconsistent with disclosures to private fund investors or fund terms
- performance and marketing deficiencies
- investment due diligence deficiencies; and
- use of hedge clauses in fund-related documents.
The biggest impact however comes in the form of the proposed transformation of Form PF for private funds which significantly increases the compliance burden of private funds, if the proposals are adopted as expected.
Public mutual funds have long argued that private funds benefit from regulatory arbitrage when compared to the levels of compliance, disclosure and reporting obligations public funds bear. Private funds’ counterpoint is that that the SEC’s current focus for investor protection goes too far since their investor demographic is purposefully sophisticated, knowledgeable, well-resourced, and doesn’t require the same protections as a retail investor base would demand.
In voting against the expanded Form PF commissioner Hester Peirce, explained in a statement: “The proposal’s focus on protecting private fund investors by shaking information loose from what we deem to be uncommunicative private funds and shutting down practices we deem to be unfair is a departure from the Commission’s historical view that these types of investors can fend for themselves.”
The Form PF reporting proposals imply a new, potentially more interventionist, posture by the SEC, particularly during times of systemic market stress. The proposals request large volumes of additional information in a one-day time frame.
It will now require next business day reporting of critical events by hedge funds and private equity funds, decrease the reporting threshold for large investment advisors from $2 billion to $1.5 billion, and require private equity advisers to gather information on fund strategies and leverage.
This means an additional burden for those advisors to complete and submit an SEC report within a 24-hour window. This is because the SEC wants the ability to decipher whether an issue is firm-specific or has wider systemic risk ramifications. For example, in the case of Archegos, when multiple prime brokers are taking identical large positions, they may not be aware that others are doing the same. So, the SEC is asking for much more detailed information on a timely basis, as it needs to know if an event is specific to one manager or a systemic threat.
In addition, advisors must implement information systems and process controls to monitor for the reporting triggers on an ongoing/daily basis. This is no small revision, and the burdens and costs would fall disproportionately heavily on those advisers with less scale and resource. Compounding this effect, the private equity fund adviser questions are purposefully framed by the SEC to deeply interrogate the operations of portfolio companies.
The Archegos Effect
Much of the recent SEC transparency agenda, including the Form PF revisions are a clear response to wider market disruption in 2021 caused by the collapse of Archegos Capital Management.1 This cost several investment banks that acted as the fund’s prime brokers an estimated $6.7 billion. While family offices are still exempt from reporting requirements in the revised Form PF, the SEC is separately looking at rules requiring dealers to disclose positions in securities-based swaps. Archegos had used total return swaps with different prime brokers, sidestepping the need to report a controlling position in certain stocks.
“The limited transparency in this market combined with market participants’ risk management, contributed to firms’ taking overly large positions and to subsequent system-wide tremors when firms started to unwind those positions,” SEC Chairman Gary Gensler said of Archegos in July 2021. The Archegos crisis also prompted the House Committee on Financial Services to consider a proposed law to require family offices with more than $750 million in assets to disclose investments in the same way as private equity funds.
Under the new rules, a reporting event would include any extraordinary investment losses of 20% or more, major withdrawals or redemptions, significant counterparty defaults and large margin calls, as well as material changes in unencumbered cash or significant operational events. This proposal left unclear if the change in prime broker reporting requirements means a complete change or merely shifting most of your business to a different prime broker. The filings will remain non-public, however, under the SEC proposal.
In addition, the amendments to Form PF require managers to get annual financial audits by an auditor certified by the Public Company Accounting Oversight Board and to document their annual compliance reviews.
Advisors must also provide their investors with an independent opinion on the fairness of the advisor-led secondary transaction. It also prohibits advisors from using certain types of fees and compensation schemes.
Advisors need to conduct what is called a reasonable inquiry into each investment to ensure advice is not based on inaccurate or incomplete information. They also should be sure that limits to their liability in disclosure documents are not misleading or in violation of the Investment Advisers Act of 1940.
The SEC recently began an enforcement action against a New Jersey manager for failing to disclose conflicts of interest and mis-stating fee information, a sign that the new rules will be enforced against managers that fail to fully disclose their conflicts and other issues.
In summary, the proposals are wide in their scope and breadth and are consequential to all private funds’ advisors in the United States. It is likely that there will be a requirement for most to invest in and implement new systems and controls to monitor for triggers to reportable events. This will require staff training and adds an additional burden at times of market stress due to the very aggressive reporting window specified. Beyond the specifics of Form PF, it is increasingly obvious that large private fund advisors face a more intrusive regulatory regime and there could be more to come on this new dawn of transparency at the SEC.
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