TOP STORY—Gensler comments on private funds regulation at the Institutional Limited Partners Association Summit - 15 November 2021

The SEC chair spoke about the importance of certain of these funds to our capital markets and potential Commission action in this area.

In prepared remarks for a recent summit, SEC Chair Gary Gensler discussed why funds such as private equity and hedge funds matter to the capital markets. He said that they matter because such funds are large, and they’re growing in size, complexity, and number. The size and transaction activities of these funds represent a critical portion of our overall capital markets, he added. But more than that, these funds matter because of what, or who, stands on either side of them.

Parties. The funds pool the money of other people, namely the limited partners, Gensler pointed out. Sometimes, they are wealthy individuals, but often they are retirement plans or non-profit and university endowments. And the people behind those funds and endowments often are teachers, firefighters, municipal workers, students, and professors, Gensler said.

The people on the other side of those funds are entrepreneurs trying to turn big ideas into big companies, Gensler said. They can be small business owners looking to hire employees, invest in new technologies, and grow. They could also be the managers of late-stage companies, bought and sold by private equity firms, Gensler said.

Is SEC meeting its mission? Gensler wonders if it’s worth asking ourselves at the SEC whether we’re meeting our mission with respect to this “important slice of the capital markets.” Is the Commission protecting investors, facilitating capital formation, maintaining fair, orderly, and efficient markets in the middle?

Conflicts of interest. When someone else’s money is being managed, there may be opportunities for conflicts of interest between advisers and investors. Moreover, for an outside investor, it can be hard to evaluate that fund. So Congress decided that there should be additional laws and rules for individuals and companies that managed other people’s money. Those dual statutes, the Investment Advisers Act and Investment Company Act of 1940, continue to be the basic framework for investment funds and their advisers today, Gensler said.

While today everyone recognizes the basic elements of asset management regulation, until recently, many of these foundational laws generally didn’t apply to private fund advisers, Gensler pointed out. It took the financial crisis in 2008 for Congress to address bringing private fund advisers into the Advisers Act. Lawmakers saw that private funds not only were large; they also were systemically important to our economy, and they had implications for investor protection, Gensler said. He thinks it’s time to take stock of the rapid growth and changes in this field, and bring more “sunshine and competition” to the private funds space. He considers the underlying principles of efficiency, competition, and transparency; market integrity; and resiliency—these three principles map to that middle arm of our mission to maintain efficient, fair, and orderly markets.

Efficiency, competition, and transparency. Gensler said that he thinks “we can promote additional transparency around fees and expenses to fund investors.”

Private equity fees might add up to 3-4 percent in private equity and 2-3 percent per year in hedge funds. Against these $9 trillion in net assets under management, there may be somewhere in the range of $250 billion that are going to fees and expenses each year, Gensler said. And that may not even be counting other fees that private funds collect from limited partners and portfolio companies.

In aggregate, Gensler said, these fees can be significant to our economy and our capital markets. Hundreds of billions of dollars in fees and expenses are standing between investors and businesses. Gensler feels that more competition and transparency could potentially bring greater efficiencies to this important part of the capital markets. That’s why he has asked the staff to consider what recommendations they could make to bring greater transparency to fee arrangements.

Side letters. Unlike in the public markets and mutual funds, private funds can select which investors they’re letting in and on what terms, Gensler said, and there’s been an increasing use of differential terms to investors. While some of these side letters are benign, related to the specific paperwork a limited partner might need based upon its tax treatment, others can create preferred liquidity terms or disclosures, So Gensler has asked staff to consider recommendations regarding how the SEC can level the playing field and strengthen transparency, or whether certain side letter provisions should not be permitted at all.

Performance metrics. There is debate about whether private equity outperforms the public markets net of fees, taking into account leverage and liquidity, Gensler said, but he is not weighing in on that debate. Regardless of an economic debate about whether various forms of private funds outperform public markets on a risk-, liquidity-, and leverage-adjusted basis, there may be benefits to fund investors from increasing transparency of the performance metrics, Gensler claimed. Therefore he has asked staff to consider what we can do to enhance such transparency.

Market integrity. Gensler next discussed fiduciary duties and conflicts of interest. Sometimes, general partners seek waivers at the state level of their fiduciary duties to investors, he said. He understands that many limited partners have concerns about these waivers. Gensler noted that an investment adviser to a private fund has a federal fiduciary duty to the fund enforceable under the Advisers Act that may not be waived. Contract provisions purporting to waive the adviser’s federal fiduciary duty are inconsistent with the Advisers Act, Gensler pointed out, regardless of the sophistication of the client. He has asked how the SEC can better mitigate the effects of conflicts of interest between general partners, their affiliates, and investors. This could include considering the need for prohibitions on certain conflicts and practices, he added.

Form PF. Finally, Gensler turned to ‘resiliency.” He thinks that Form PF, which is how hedge funds and private equity funds provide information about their activities to the government and is an important barometer of financial system resiliency, needs to be “freshen[ed] up.” Gensler has asked staff to make recommendations to the SEC, to consider enhancing reporting and disclosure through Form PF or other reforms. Gensler said, “We are working with our sibling agency, the Commodity Futures Trading Commission, on potential joint rulemaking, as well as with partners at the Financial Stability Oversight Council, the Department of the Treasury, and the Federal Reserve.”

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