-
19. Feb 2024
-
Financial regulators are training their sights on one of the most robust sectors of the U.S. economy in recent decades: private equity.
Private Equity Consulting Learn more
In August, the Securities and Exchange Commission approved new disclosure rules for private equity fund managers, including those with substantial real estate holdings.1, 2 Intended to provide more transparency and consistency to the investor community, these rules will soon require private fund managers to file quarterly statements, obtain third-party valuations, conduct annual audits and meet other mandates.3
While the first of these new rules — an annual recordkeeping requirement for Registered Investment Advisers (“RIAs”) — went into effect in November, fund managers will have until March 2025 to implement them fully.4 The new requirements, which total more than 650 pages, are an attempt by financial regulators “to protect investors who directly or indirectly invest in private funds” by forcing them to comply with disclosure rules similar to those of publicly traded companies.5
Unlike their large publicly traded counterparts, however, most private equity firms and real estate funds typically do not have large in-house compliance departments that can readily absorb new complex administrative and legal functions. Understanding the SEC’s recent mandates can help fund managers — especially at small and midsize firms — make the best long-term decisions for their firms and their clients.
‘Enhancing Advisers’ Transparency’
The origins of private equity and real estate funds go back to the 1980s, when a new form of corporate acquisition, the “leveraged buyout,” began to dominate business headlines.6 These early transactions, which typically involved individuals or small groups of investors buying undervalued or asset-rich publicly traded companies on credit, eventually gave way to an operations-focused approach that emphasized financial fundamentals, corporate turnarounds and scaling or consolidation.7
Today, private equity and real estate funds are a fixture in virtually every part of the U.S. economy. According to the American Investment Council, 11 million Americans are employed by businesses owned by private equity firms, which invested more than $1 trillion in U.S. companies in 2021.8 The reasons for this staggering growth are simple: In the past 20 years, private equity has generated average rates of returns of 15 percent,9 or about 50 percent more than the S&P 500 over the same period.10
Looking ahead, long-term low interest rates and other macroeconomic factors that contributed to the high-growth environment for private equity and real estate funds during the past decade are not expected to continue in the coming years. Even more, some industry observers are predicting that the SEC’s new rules may have a “cooling” effect on smaller shops and the handshake arrangements and side deals that were once the norm among firms, their partners and their clients.11
In announcing the new rules, SEC Chairman Gary Gensler suggested that this result may not be accidental.
“Private funds and their advisers play an important role in nearly every sector of the capital markets,” Gensler said in a statement. “By enhancing advisers’ transparency and integrity, we will help promote greater competition and thereby efficiency.”12
Meeting the Requirements
Under the SEC’s new rules, RIAs will now be required to distribute a quarterly statement to all investors that includes performance, costs of the fund and related fees and expenses. RIAs will also be required to complete an annual financial audit, obtain a fairness or valuation opinion for any secondary sales and document an annual review of compliance-related policies and procedures.
To meet these new rules, private equity firms and real estate funds for the first time will be required to engage with auditors and independent third-party valuation experts. Fund managers will need to develop an all-encompassing decision roadmap for planning and resource allocation purposes, a requirement that will also likely benefit from the assistance of outside consultants.
But perhaps the most challenging new requirement for many firms and funds? Analysis and analytics that may be beyond the capabilities of the industry’s favorite tool, Excel spreadsheets. To meet the new quarterly statement requirements, private equity firms and funds — many of which have run substantial aspects of their portfolios on Excel — may now need to onboard more complex technology platforms that allow them to collect and aggregate detailed data on fund performance as well as the costs, fees and expenses related to the private equity firm or real estate fund’s operations.
Operational Effects
Given the hefty compliance requirements, the SEC’s new rules are already upending private equity firms and real estate funds. For all but the largest fund managers, for example, the necessary technology and automation investments — as well as human resources and risk management — likely will be cost prohibitive.
Still, even if the new SEC requirements can be met using internal resources, many private equity firms and real estate funds will look to outside service providers to manage their back offices, because — as hedge fund managers discovered a decade ago — it puts their clients at ease and allows them to focus on their core competency of investing.
As subsequent agency guidance and court decisions emerge, legal interpretations of the SEC’s latest requirements are expected to continue evolving in the coming months and years. For many firms and fund managers, the juice simply won’t be worth the squeeze: Even if they could stay on top of developments, many RIAs will choose to enlist end-to-end fund administrators that can continuously monitor legal and compliance issues, as well as support their operations, fulfill reporting requirements, and maintain the technology and automation necessary to comply with the SEC’s new rules.
Footnotes:
1: Securities and Exchange Commission Rin 3235-AN07 summary. Securities and Exchange Commission (accessed Jan. 30, 2024).
2: Fact Sheet Private Fund Adviser Reforms: Final Rules. Securities and Exchange Commission (accessed Jan. 30, 2024).
3: Ibid.
4: “SEC News Roundup: Private Funds Rule Compliance Date Set, Nine Investment Advisers Charged in Breach of Marketing Rule, in Rare Action, Investment Adviser Found to be Acting as an Illegal Broker-Dealer,” Gibson Dunn (Oct. 3, 2023).
5: Securities and Exchange Commission Rin 3235-AN07 summary. Securities and Exchange Commission (accessed Jan. 30, 2024).
6: Daniel Murphey et al., “The New Math of Private Equity Value Creation,” Goldman Sachs (Oct. 31, 2023).
7: Ibid.
8: “Private Equity in Your Community,” American Investment Council (accessed Dec. 31, 2023).
9: Daniel Murphey et al., “The New Math of Private Equity Value Creation,” Goldman Sachs (Oct. 31, 2023).
10: J.B. Maverick, “S&P 500 Average Return and Historical Performance,” Investopedia (Dec. 1, 2023).
11: Arleen Jacobius, “SEC private funds rule improves transparency, but headaches loom for managers,” Pensions & Investments (Aug. 25, 2023).
12: “SEC Enhances the Regulation of Private Fund Advisers,” Securities and Exchange Commission (Aug. 23, 2023).
About The Journal
The FTI Journal publication offers deep and engaging insights to contextualize the issues that matter, and explores topics that will impact the risks your business faces and its reputation.
Related Insights
Related Information
Datum
19. Feb 2024
Ansprechpartner
Senior Managing Director