Proposed SEC Rule on Private Fund Advisers

William W. Clayton is an Associate Professor at Brigham Young University Law School. This post summarizes his recent comment letter to the U.S. Securities and Exchange Commission.

The SEC recently published a proposed rule (the “Proposal”) that would impose unprecedented mandatory disclosure obligations and various other forms of intervention in the private funds industry. [1] On April 21, 2022, I filed a comment letter in response to the Proposal. [2] My letter addresses what appears to be one of the most profound sources of disagreement between proponents and opponents of SEC intervention in the private funds industry: the question of whether investors and managers in private funds can be assumed to bargain effectively.

My comment letter has four primary objectives. First, it discusses the heightened importance of understanding the limits of private market bargaining as the SEC considers this new phase of regulatory activity. Second, it provides new insight into how private equity investors think about bargaining problems by introducing recent polling data obtained from institutional investors. Third, it encourages the SEC to be more explicit about identifying and articulating the bargaining problems that it believes are producing the problematic outcomes described in the Proposal, and it also calls for greater scholarly engagement with these issues going forward. An explicit assessment of private fund bargaining limitations should play a central role in the cost-benefit analysis of any regulatory interventions in this space. Lastly, it includes a brief discussion of certain of my papers that were cited by the SEC in the Proposal. My letter does not analyze the extent of the SEC’s formal rule-making authority in this area.

The Importance of Understanding the Limits of Private Bargaining

My letter starts by observing that there is an enormous gap between the way that proponents and opponents of the Proposal think about private ordering in private funds. Unlike the SEC staff, there are many who think bargaining is working just fine in private funds and that the Proposal’s recommendations are not responding to the industry’s actual needs. [3] This disagreement between interventionists and contractarians is thus not just about the SEC’s proper policy role, but also about the basic facts on the ground about how bargaining does (and does not) work in private funds.

For perspective, I compare this current debate with an earlier policy debate in the public company arena. Decades ago, prominent scholars disagreed over whether mandatory disclosure requirements were needed in the public company marketplace. Some advanced the contractarian view that mandatory disclosure rules were unnecessary in the public company marketplace because companies were already incentivized to provide disclosure voluntarily to lower their cost of capital. [4] However, scholars responded by arguing that, in reality, public companies were likely to under-produce disclosure due to collective action problems and agency problems. Over time, this rebuttal gained wide acceptance and has been called a “consensus view” among securities law scholars today. [5]

Recognizing this history in the public company domain has two important implications for today’s policy debate in the private funds setting. First, this history suggests that sophistication by itself may not be enough to ensure effective bargaining. After all, the general scholarly consensus is that public companies fail to produce optimal levels of disclosure voluntarily not because of unsophistication, but because of collective action problems and principal-agent problems. There is little reason to assume that private markets are impervious to similar problems. Second, notwithstanding that fact, an important difference between the public company mandatory disclosure debate and the current private markets debate is that private market policymakers and commentators seem much less aligned on what exactly the bargaining problems are in private funds. This is not entirely surprising, given the private status of this market, but it makes reaching any sort of policy consensus far more difficult.

How Investors Think About Bargaining Problems in Private Equity Funds

Scholars (including myself) have set forth various possible theories for why there might be problematic bargaining outcomes in private equity funds. [6] While this work has produced many useful insights, it has been limited by the fact that scholars have largely been prevented from gaining access to basic fund documents in private funds.

In the Proposal, the SEC sets forth various explanations for why bargaining in private funds might be leading to unsatisfying outcomes. [7] Interestingly, these explanations are spread throughout the Proposal and are not presented as part of a unified thesis for why suboptimal bargaining happens in this industry. They also tend to be somewhat impressionistic and anecdotal, and the SEC acknowledges that there is a lack of data about how private equity business practices would be affected by the proposed prohibitions. The Proposal generally does not seek industry commentary on its characterizations of the problems that prevent effective bargaining in private funds.

My letter seeks to introduce the perspective of a broad range of institutional investors by presenting the live polling results of over 90 institutional investors obtained during the annual Private Equity Legal Conference of the Institutional Limited Partners Association in October 2021. [8] During my interactions with institutional investors and their external counsel over the years, I have found that it is very common for institutional investors to comment on how challenging the private equity bargaining landscape is. [9] Given this background, I was curious to use this polling session to ask the audience two general questions: (1) “Why do investors accept terms in private equity funds that they find problematic?”; and (2) “Do investors want to see regulatory reforms?” [10]

With respect to the first question, the most common response from institutional investors (by far) was that they accept problematic terms because of a fear of losing allocation, which suggests that there may be a coordination problem among investors. Investors appear to be worried that if they insist on high-quality terms, their allocation to the current fund and/or future funds might be given to other investors that are willing to tolerate weak terms. Full results are discussed in Section I.E(1) of the comment letter.

To address the second question, respondents were presented with the prompt “What regulatory reforms are needed?” and given the ability to select as many options as desired out of a set of seven options. The results show substantial investor support for regulatory interventions. Interestingly, the two reforms most frequently selected by respondents aligned with two of the most important priorities of the Proposal: imposing mandatory fee and expense reporting requirements and dealing with adviser conflicts of interest. Support for regulatory reform, however, appeared to fall short of either unanimous or super-majority approval. Full results are discussed in Section I.E(2).

All in all, the polling results raise questions about the contractarian view of private equity funds. A substantial percentage of investors seems to think that the bargaining outcomes in private funds are problematic and desires various forms of regulatory intervention, and the preferred policy interventions of the respondents generally appear to align with some of the dominant policy priorities of the Proposal. The polling results also provide some insight into the nature of bargaining problems in private equity funds. Investors say that they shy away from demanding high-quality terms primarily because they are afraid that if they do so, their investment allocations will be given to more accommodating investors that are not raising such concerns.

The discussion above generally assumes that institutional investors are well-positioned to comment on whether they experience bargaining impediments that lead to problematic outcomes in their private fund investments. One reasonable objection, however, might be to question whether this is really true. Some of the senior attorneys responding to the polling questions could, for example, suffer from principal-agent problems. This could lead them to advocate for regulatory reforms even if the expected costs (in the form of reduced competition and/or increased cost of capital) would outweigh the expected benefits for industry participants. Alternatively, the respondents themselves could be unsophisticated in the way that they operate in their roles.

It is difficult to know what to make of this possibility, given the limited available data. However, if this argument is true, the effect would not necessarily be to bolster the contractarian critique of SEC intervention. To the contrary, one could argue that evidence of widespread principal-agent problems and/or sophistication problems would serve as an even stronger challenge to the contractarian thesis that investors can be relied on to bargain for effective outcomes.

My Suggestions

The polling data presented in the letter shows that many institutional investors think there are bargaining problems in private equity funds and want to see significant regulatory interventions to address those problems. It also provides insight into which specific problems investors think are having the most significant impact on bargaining outcomes. While this is helpful, the data admittedly raises nearly as many questions as it resolves.

My comment letter offers two suggestions. First, if the SEC proceeds with a final rule, I encourage the staff to be even more explicit about articulating the bargaining problems in private funds that it believes are leading to problematic outcomes (based on its perspective gleaned from examinations, investigations, and elsewhere). As noted above, much of the analysis of bargaining problems in the Proposal is spread throughout the Proposal. I would encourage the staff to include a more robust and unified discussion of bargaining problems in its initial framing of the rule and be more explicit about how the various aspects of the rule respond to those problems. Moreover, to the extent that the SEC has access to more data that provides additional insight into bargaining problems or has received additional detail from industry commenters on bargaining problems during the comment process, I encourage the staff to include that information in the final rule.

Second, I think it is important to note that even if a final rule is issued, ongoing research into these issues will continue to be very important. Private funds have long been an understudied topic in the legal literature. While this fact is not surprising due to the challenges of researching in this area, it is an extremely important policy area that needs more theoretical and empirical contributions from scholars. Accordingly, I call on corporate finance scholars and securities law scholars to find thoughtful ways to make these contributions in coming months and years. The same need exists in the private operating company domain. [11]

As noted above, the letter does not purport to analyze the boundaries of the SEC’s formal rule-making authority in this area.

Brief Discussion of My Research Cited in the Proposal

My letter closes with two brief comments on certain of my research papers cited by the SEC in the Proposal. [12] First, it emphasizes that while each of those papers discusses various problematic aspects of private equity fund governance, they do not purport to measure the policy benefits of any regulatory interventions or weigh them against the policy costs. As such, they do not advocate for any particular policy responses by the SEC (contrary to recent suggestions otherwise), and they do not consider questions of the SEC’s regulatory authority. The letter also discusses some implications of important new research [13] for how we understand inter-investor conflicts of interest in private equity funds—a topic that I previously examined in two earlier papers.

Conclusion

The SEC’s Proposal and the range of reactions that it has elicited has underscored the importance of articulating and understanding the limits of private contracting in this new era of more aggressive proposed private fund regulation. My comment letter calls attention to this need and contributes new data on what investors think about bargaining problems in private equity funds. It encourages the SEC to be more explicit about articulating the relevant bargaining problems driving its policy decisions and also calls for more scholarly engagement in this area going forward. A direct analysis of private fund bargaining limitations should play an important role in the cost-benefit analysis of any regulatory interventions in this industry.

The full comment letter can be downloaded here.

Endnotes

1Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, Investment Advisers Act Release No. 5955, 87 Fed. Reg. 16,886 (Mar. 24, 2022), https://www.govinfo.gov/content/pkg/FR-2022-03-24/pdf/2022-03212.pdf [hereinafter SEC Proposal].(go back)

2Clayton SEC Comment Letter (Apr. 21, 2022), https://www.sec.gov/comments/s7-03-22/s70322-20125350-284820.pdf.(go back)

3See, e.g., Commissioner Hester M. Peirce, Securities & Exchange Commission, Statement on Proposed Private Fund Advisers; Documentation of Investment Adviser Compliance Reviews Rulemaking (Feb. 9, 2022), https://www.sec.gov/news/statement/peirce-statement-proposed-private-fund-advisers-020922 (“[T]he 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.”) (italics in original); The Editorial Board, The SEC’s Private Market Takeover, Wall St. J. (Mar. 15, 2022) (“The SEC doesn’t exist to protect sophisticated investors. Mr. Gensler wants to expand the agency’s mission from protecting Granny’s life savings to shielding deep-pocketed investors from risks they freely take. The California Public Employees’ Retirement System (Calpers) manages more assets than KKR. How is it at a disadvantage?”); Harvey Pitt, SEC Comment Letter (Apr. 18, 2022), https://www.sec.gov/comments/s7-03-22/s70322-20123886-280060.pdf.(go back)

4See, e.g., Frank H. Easterbrook & Daniel R. Fischel, Mandatory Disclosure and the Protection of Investors, 70 Va. L. Rev. 669 (1984); Stephen Ross, Disclosure Regulation in Financial Markets: Implications of Modern Finance Theory and Signaling Theory, in Issues in Financial Regulation 177, 183-93 (Franklin R. Edwards ed., 1979).(go back)

5See, e.g., Merritt B. Fox, Retaining Mandatory Securities Disclosure: Why Issuer Choice Is Not Investor Empowerment, 85 Va. L. Rev. 1335, 1339 (1999) (describing the “rough consensus” achieved in the mandatory disclosure debate during the 1980s); Andrew A. Schwartz, Mandatory Disclosure in Primary Markets, 2019 Utah L. Rev. 1069 (2020) (“Thanks to these two very powerful ideas [i.e., agency costs and information underproduction], the modern theory of mandatory disclosure has achieved hegemony in the field. Nearly all scholars support the idea, both in the United States and around the world.”).(go back)

6See Clayton SEC Comment Letter, supra note 2 at Sec. I.D.1.(go back)

7See Clayton SEC Comment Letter, supra note 2 at Sec. I.D.2.(go back)

8Importantly, this survey data applies specifically to private equity funds and not to other types of private funds.(go back)

9This input is consistent with statements that have been made by ILPA over the years. See, e.g., Letter from Institutional Ltd. Partners Ass’n to Brent Fields, U.S. Sec. & Exch. Comm’n Sec’y, Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation—File No. S7-09-18, at 9 (Aug. 6, 2018), https://ilpa.org/wp-content/uploads/2018/08/ILPA-Comment-Letter-on-SEC-Proposed-Fiduciary-Duty-Interpretation-August-6-2018.pdf.(go back)

10The original survey consisted of 10 questions, and I discuss a few of the most salient results in the comment letter. All polling results (with the exception of one question containing sensitive information) can be viewed in Appendix A of the letter.(go back)

11See generally Paul Kiernan, SEC Pushes for More Transparency from Private Companies, Wall St. J. (Jan. 10, 2022).(go back)

12See SEC Proposal, supra note 1 at fns. 8, 146, 173, 192, and 250.(go back)

13Elisabeth de Fontenay & Yaron Nili, Side Letter Governance, Wash. U. L. Rev. (forthcoming) (challenging the extent to which economically significant terms are located in side letters).(go back)

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