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SEC private equity proposals ‘significantly increase barriers’ for smaller firms

New proposals from the US Securities and Exchange Commission (SEC) aimed at improving transparency in private equity will “significantly increase barriers” for smaller firms, according to one expert.

Kay Gordon, a US investment funds expert with Nelson Mullins Riley & Scarborough LLP, said the plans – which include requirements for private equity firms to provide third party investors with detailed quarterly statements about fund performance, fees and expenses - would “increase the costs that are much more easily borne by larger advisers”.

In a document published last week (341 pages / 1.62MB PDF), the SEC also suggested a ban on various fees that private equity firms, known as general partners (GPs), sometimes charge third party investors, known as limited partners (LPs). The proposals would prevent GPs from making LPs pay for taxes that GPs incur on their carried interest in the event of a clawback situation. The SEC would also force GPs to disclose any preferential treatment to some LPs, including discounted management fees, to all current and prospective LPs.

The SEC said the changes were intended to prevent GPs from "engaging in certain activities and practices that are contrary to the public interest and the protection of investors,” but Gordon warned that the proposals would “significantly increase barriers to entry into the industry for smaller fund advisers”.

Kay Gordon

Partner, Nelson Mullins Riley& Scarborough LLP

Smaller fund advisers will be required to ensure that, much like mutual fund advisers, they comply with the extensive disclosure requirements through detailed quarterly statements

She added: “These advisers will be required to ensure that much like mutual fund advisers, they comply with the extensive disclosure requirements through detailed quarterly statements, and they will also have to provide written disclosures to prospective and current investors of side letter terms, including excuse rights and fee discounts.”

Gordon also said that the requirements would leave smaller GPs more exposed and unable to compete because many lack access to legal counsel often only available at larger law firms that can draft SEC-mandated disclosures “in a manner that is protective”. She added that strategic investors commonly used by many fund advisers may also be unable “to receive certain information about a fund’s portfolio investments without the fund having to share that information with all of its existing and potential investors”, a move which could damage the fund’s ability to utilise its strategic investors’ expertise.

Gordon warned that, unlike the Dodd-Frank Act, which overhauled Wall Street regulation in 2010, some of the SEC’s requirements “would also apply to unregistered investment advisers, such as venture fund advisers, and thus would highly negatively impact venture capital financing which is the engine of the US economy”.

Elaine MacGregor, investment funds expert at Pinsent Masons, said the new proposals would be welcomed by smaller institutional investors who would benefit from greater transparency “as well as prohibitions on certain practices which they may not have previously been aware of”. But she added that more experienced investors may feel concerned that the new restrictions on preferential treatment “could impact meeting their bespoke requirements and potential hinder the fund-raising process”.

“This may also lead larger investors to seek more tailored solutions instead, such as the increasingly popular separately managed accounts,” MacGregor added.

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