‘Prudential’ shift seen behind Form PF rule change

Compliance's 'one-way ratchet' may mean fewer, bigger firms in the private funds industry.

The US Securities and Exchange Commission’s new Form PF rules are more modest than what regulators first proposed. Still, some private fund advocates still see regulators shifting their focus from making sure funds disclose risks to making sure firms prevent risk.

“You hear people arguing that, under the new Form PF rules, the SEC should move towards being a prudential regulator,” says Brian Daly, a partner with law firm Akin Gump’s investment management team.

“It says all over the adopting release that its purpose is to provide information to the Financial Stability Oversight Council. Many of the statements from SEC commissioners and staffers say that private funds are controlling more assets than the US banking system. So now you’re too big to fail.”

A divided commission adopted the new Form PF rules at its open meeting on 3 May. They have changed Form PF – the confidential report all registered private fund advisers must file at least once per year under Dodd-Frank – so that firms must give more detail about themselves, more often.

Private equity firms must report adviser-led secondaries deals or a general partner’s exit within 60 days of the end of the next quarter. Daly and other private fund advocates say the rules represent a potentially tectonic shift in the way the $25 trillion industry is regulated.

Disclosure to prevention

The SEC’s power rests on disclosure. Its job has been to police markets so that companies and fund advisers are being open and honest with investors about how their businesses work and where the risks lie. Prudential regulators such as the Federal Reserve focus on keeping markets stable.

The FSOC came out of the Dodd–Frank Wall Street Reform and Consumer Protection Act that was designed to prevent another financial crisis in the aftermath of the 2008 global financial crisis. It’s a prudential regulator led by treasury secretary Janet Yellen, and its members include the Federal Reserve, the SEC and other agencies. Under the Trump administration, the FSOC was all but defunded, Daly says. Under the Biden administration, the council is not only making a comeback; it is beginning to take on a gravity of its own in the private funds industry. The new Form PF rules will help the Council bulk up, Daly says.

“If you read the Form PF release, it really is all about FSOC,” Daly tells affiliate title Regulatory Compliance Watch. “The FSOC sits alongside the SEC, benefiting from the new system the SEC is putting in place; it will police and monitor, but for completely different purposes. You can see how the FSOC might evolve into an actual, legitimate risk monitor.”

‘A regime that doesn’t exist’

FSOC officials did not respond to RCW’s requests for comment. The SEC says it needs the new Form PF rules for two reasons. The first is to get a handle on systemic risk; the second is to “strengthen the effectiveness of the commission’s regulatory programmes, including examinations, investigations, and investor protection efforts”, regulators say in the adopting release.

Most private fund advocates are worried about that second part more than the first. “They say they want you to report all this information and it goes into their little black box,” says Greg Larkin, a partner with law firm Goodwin Procter. “But you have to imagine that you’re more likely to be examined if you’ve engaged in an adviser-led secondary transaction. The problem with the SEC wanting to be a prudential regulator is that they don’t have the authority to do anything like that.”

That’s why the FSOC is so important, Akin’s Daly says. The 3 May adopting release mentions the council 169 times. In essence, Daly says, SEC chairman Gary Gensler is outsourcing prudential regulation to another regulator. “In a way,” Daly says, “the SEC is a very constrained agency. The lines are very clear and established and hard to move. The FSOC, on the other hand, is a clean sheet of paper. These new rules are all for the benefit of a future regime that doesn’t exist yet but that they’re laying the groundwork for.”

If Daly’s right – and he’s not the only person in Washington making this kind of argument – the implications for the private fund industry are enormous.

“If you are pushing a regulatory agenda that requires far more of an investment in compliance management infrastructure, costs go up. It’s a one-way ratchet,” Daly says. “But it also means that you generally wind up with fewer, but larger, players. If you want world-class compliance systems, you’re probably not investing with a $15 million start-up manager.”

Regulators estimate that implementing the new Form PF rules will cost the industry nearly $146 million – about $44,000 per firm – over the next three years. Most experts RCW talked to agreed that those estimates are low.

SEC officials did not respond to RCW’s requests for comment. But Gensler and his aides have suggested they’re not creating the problem of scale, they’re merely addressing it. In the adopting release, for instance, regulators say five different times that large private equity advisers – those with at least $2 billion in AUM – already control 73% of the market.

Fees (and expenses)

Separately, Gensler and his allies have argued that even as the private fund industry has exploded – the net AUM reported on Forms PF tripled between 2014 and 2022, and the number of funds advised grew by 110 percent, the adopting release claims – industry fees haven’t shrunk despite the widening competition.

In other words, some advocates hear regulators saying, ‘Don’t talk to us about your compliance costs: It’s the least you can do to protect the markets.’

“I think it’s a trend at the SEC, pushing regulatory monitoring onto the firms so the SEC can be reactive, can be on the receiving end of the data,” says Christine Lombardo, a partner with law firm Morgan, Lewis & Bockius. “The SEC clearly thinks the industry has the resources to do it. These are serious obligations. Investment in compliance and legal and infrastructure is something all firms are going to have to be reassessing when they think about their businesses.”

End game

Parikshit Dasgupta, a partner at law firm Hogan Lovells, says he’s not quite ready to sign off on the prudential regulator thesis and that the SEC has become increasingly prescriptive with private funds in the decades since Dodd-Frank came on the books. He wonders what ailment regulators are trying to cure with the new Form PF rules.

“I’m not sure, really, what the end game here is,” he tells RCW.

Consider the SEC’s focus on continuation funds and GP-led secondaries, Dasgupta says. In the Form PF adopting release, regulators acknowledge that neither continuation funds nor secondaries deals are a sign of distress. However, they do note that such deals “include a higher potential for conflicts of interest or fund distress” that “generally may signal an investor protection issue at a particular fund”.

It’s an odd way to think about those funds, Dasgupta says. “There may be higher potential for conflicts of interest, but that does not equate to distress in the assets. In our experience, GP-led secondaries and continuation funds help investors achieve longer beneficial ownership in a growing business, and are not typically used for selling zombie/distressed companies. The secondary investor market is very sophisticated and ensures proper pricing.”

Not done yet

Whatever the market thinks of the new Form PF rules, remember that the SEC isn’t done yet. Still pending are even more Form PF rules (in conjunction with the CFTC), rules that would ban a host of fees and expenses, rules that would require advisers to monitor their outside vendors more closely and more often, and new safeguarding and custody rules.

That’s why so many private fund advocates, relieved as they are that the latest Form PF rules weren’t harsher, aren’t letting their guard down.

“From a big picture perspective, the new Form PF rule in and of itself will have some operational challenges, but it’s not a big-bang change – at least not for private equity advisers,” says David Blass, a partner with law firm Simpson, Thacher & Bartlett in Washington.

“But you have to interpret this rule in the broader context of the SEC’s regulatory agenda. It’s one of many pieces to a puzzle that’s problematic for private equity advisers, especially the smaller ones. It’s almost like Jenga, where you’re pulling blocks out one at a time and hoping to keep the tower up. This isn’t the one that will make it all collapse. But when you add it all together, it’s going to create barriers to entry.”