US regulations: Coming to Asia

Private equity fund managers in Asia have generally been fortunate enough to raise capital from institutional investors in the US without being subject to auditor investigations. That’s about to change.

Transparency and compliance rules proposed by the US Securities & Exchange Commission (SEC) may raise the bar in terms of what is expected from managers, leading to meaningfully more expensive fund management and more uniform reporting. Meanwhile, usage of side letters would fall and separately managed accounts (SMAs) would proliferate to circumvent preferential treatment disclosures.

“[S]ome of these proposals would fundamentally change both existing market practices and market structure,” Daniel Austin, director of US policy and regulation at the Alternative Investment Management Association (AIMA), said in a podcast last month.

“Many of these proposals have their roots in what I think is a populist driver call for equality of information and additional transparency purely for transparency's sake.”

Most of the industry response to date has understandably been in the US, but Asian managers are advised to get involved. Most GPs in the region raising US capital are recognised by the SEC as exempt reporting advisers (ERAs), and for the first time, several proposed measures would have a significant impact on them.

“We’re now in the comment period and hope that the final rules will reflect industry feedback, which is expected to be substantial, because some proposed rules would overturn well-established market practice if adopted in their current form,” said John Fadely, a Hong Kong-based investment funds partner at Gibson Dunn.

“We immediately alerted our clients, partly so they can participate, if interested, in the rulemaking process by commenting on the SEC’s proposals.”

A tighter leash

The SEC’s concerns are easily distilled from nature of the proposed rule changes. Private equity managers are not being transparent enough about quarterly reporting, fund commitment terms and conditions, and what LPs pay in terms of regulatory and transaction expenses. There is also a clear desire to shift some economic burdens from LPs to GPs.

It’s a long unfolding regulatory theme, which has typically resulted in pushback from an industry that believes handholding is unnecessary. Fund commitments are heavily negotiated by sophisticated counterparties, who already know what information they need and what questions to ask. In this view, SEC meddling represents a prescriptive, one-size-fits-all regime that will just lead to higher legal costs.

“I don’t think there’s going to be a negative impact other than that it’s going to be more expensive to run a fund, which will be passed through to investors. That will, in turn, reduce performance because it’s a fund expense to provide this information,” said Daniel Strachman, a co-founder and managing director at the US-based Investment Management Due Diligence Association.

“Fund managers are going to call their lawyers and they’re going to say, ‘What do I have to do now to be compliant?’ The lawyers will take a look at the new rules and create a new operation manual and get new documents, and all the while the meter is running. That’s who wins this game.”

With the latest rule proposals, many Asian ERAs will participate in this policymaking process for the first time and they will have to be conscious of the SEC’s long game to engage effectively. Contrary to the assertion of AIMA’s Austin that the proposals seek transparency purely for transparency's sake, there is a broader agenda for the industry around mass-market inclusion.

“The SEC is laying the groundwork for private equity as an industry to tap into additional sources of capital and go down the value chain,” said Niklas Amundsson, a partner at placement agent Monument Group.

“We’re seeing it with wealth managers, and retail is next. Not next year, but in the next five years. For that to happen, you’re going to need reporting to be in line with what’s appropriate for retail investors. You need that transparency and regulatory support.”

Focal points

There are five main areas of the rules that would directly impact Asian ERAs. They include a proposal that co-investors bear their pro rata share of broken deal costs, which is meant to prevent fund investors from being saddled with those expenses.

While this is an understandable regulatory goal, it doesn’t capture the nuances of the co-investment process. Co-investors that negotiate from a position of strength typically refuse to bear their share of broken deal expenses, with the fund sponsor not necessarily having any ability to push back.

Second, there is a proposal to entitle LPs to 100% of carried interest clawbacks by prohibiting GPs from paying on an after-tax basis, currently the universal market practice. If a GP pays tax on carry, the clawback amount will be calculated after the tax is paid. The idea is to incentivise GPs to calculate and charge carried interest more prudently and avoid clawback situations.

Third, the SEC wants there to be no indemnification of GPs or their employees for losses that arise from breaches of fiduciary duty or simple negligence, not gross negligence. Generally, the threshold for funds indemnifying sponsors has been gross negligence, and fiduciary duty has been excluded altogether due to difficulty in defining the boundaries of the concept.

Fourth, there is a proposal to prevent GPs from using funds to cover regulatory or compliance obligations, as well as charging accelerated monitoring fees. This is likely to be less relevant in Asia, especially regarding accelerated monitoring fees, an older practice primarily seen in the US that was largely negotiated out during the difficult fundraising processes of the global financial crisis.

Fifth, and perhaps most significant, the terms of side letters must be disclosed to all LPs, including prospective LPs, before the final closing. This would represent a departure from accepted market practice, whereby investors negotiate side letter rights by their own lights, without any initial knowledge of what has been granted to other investors in other side letters.

“If sponsors were to give detailed disclosure of side letter rights in advance, then investors would start negotiating based not just on their needs and preferences, but also based on what rights they think they should obtain, relative to other investors in the same fundraise,” said Gibson Dunn’s Fadely.

“Upfront disclosure probably won’t make the side letter negotiation process any less commercially driven – it would just change the commercial dynamics, perhaps in ways that the SEC doesn’t entirely intend.”

The SEC acknowledged in its proposal that side letters providing a benefit to certain LPs did not necessarily disadvantage others. But it added that it should be up to the LPs to make this decision.

Disclosure dynamics

The greatest uncertainties on this issue relate to the extent to which managers must disclose side letters in terms of parity of information. The aim of the rule is clearly to prevent managers from providing certain LPs with an information advantage, but does this mean that all information no matter how irrelevant to other parties must be available to all investors?

In some scenarios, such a universal disclosure requirement could be decidedly problematic for GPs. For example, if an LP has been granted side letter rights that allow it to withdraw from the fund under certain circumstances, multiple investors could reasonably seek the same arrangement, potentially destabilising the fund. In other scenarios, the intention of the SEC could backfire.

“The proposed changes to disclosure requirements would empower GPs to tell LPs that they’re imposing unreasonable preferential terms,” said Serena Tan, deputy co-chair for the global private funds group at Morrison & Foerster.

“If they have to disclose those terms to every prospective LP, it would affect their ability to fundraise or the size of the fund that could be targeted. So, the rules are meant to protect LPs, but they could actually give GPs a stronger counterargument against onerous LP requests.”

Another proposal would require GPs to provide a fairness opinion from an independent third party in relation to GP-led secondary transactions, as well as a summary of any material business relationships the manager or any of its related persons has had with the opinion provider in the past two years.

The SEC said this measure would provide an important check against a GP’s conflicts of interest in structuring and leading a transaction from which it may stand to profit at the expense of LPs. But this is not expected to be among the more impactful features of the new rules.

“A fairness opinion is not worth the paper it’s written on,” one industry participant said. “It sounds like you’re giving us more protection, but you’re just going to a bank that is paid by the sponsor to provide a range of prices to call fair. I’ve not seen too many situations where the bank has come back and said, ‘I can’t give you that opinion.’”

Wait and see?

Overhanging everything is lingering uncertainty about whether the proposed rules will be grandfathered. In theory, changing entrenched ways of dealing with recurring issues would probably require grandfathering to respect existing contracts. But this has not been spelt out. As the proposals are written now, managers would, in some cases, need to breach existing side letters to stay on the right side of the law.

Loose ends of this kind are the strongest argument for the wait-and-see approach typically adopted by Asian managers whenever US regulatory changes begin going through their early development stages.

This is especially logical considering that only a small population of mega managers in the region are registered investment advisors (RIAs), those with a substantial presence in the US and full exposure to the SEC rulebook. However, now that the SEC’s jurisdiction is extending to ERAs, wait-and-see makes a little less sense.

There is also the idea that the rule changes focused on RIAs will permeate the rest of the industry, even where they are not formally required. The biggest players – whether it’s US regulators or the mega funds they govern – establish the industry’s culture and borderless conventions.

In the case of the latest proposals, RIAs are being asked to provide gross and net IRR, as well as multiple of invested capital (MOIC) and subscription line borrowing figures formatted and delivered on a quarterly basis. LPs investing in both RIAs and ERA are likely to eventually expect this level of reporting across the board.

“We’ve seen this in the past where other regulators follow the lead of the US, and the SEC sets the expectations for investors,” said Justin Dolling, a partner at Kirkland & Ellis.

“Even if new regulations are not directly applicable to GPs in Asia, we may see certain large LPs saying, ‘This is now best practice, and we expect you to abide by, or at least reconcile your metrics with, the new standard in the US.’ It’s very early days and we certainly haven’t heard any talk of this happening yet, but it’s happened before.”

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• Topics
• Fundraising
• GPs
• Regulation
• North America
• Asia
• Us securities and exchange commission (sec)
• regulation
• Co-investment
• Fund formation