With private fund advisor rules firmly in the SEC’s compliance crosshairs, a majority of US managers say they are concerned about the regulator’s far-reaching proposals, which could bring significant operational and compliance burdens and substantially impact certain hedge fund strategies.
With private fund advisor rules firmly in the SEC’s compliance crosshairs, a majority of US managers say they are concerned about the regulator’s far-reaching proposals, which could bring significant operational and compliance burdens and substantially impact certain hedge fund strategies.
The Securities and Exchange Commission is taking an increasingly strident approach towards market regulation under chair Gary Gensler, with new proposals covering private fund advisors, environmental, social and governance (ESG) disclosures, and digital assets and cryptocurrencies, among other things, potentially heralding sweeping changes to financial services in the US.
In particular, the private fund advisor rules as proposed are set to dramatically alter investment managers’ relationships with clients.
Under the SEC’s private fund advisor proposals, which are aimed at strengthening transparency for investors, hedge funds and other private and alternative fund managers would be required to provide quarterly statements and detailed annual audits to clients. The plans also call for changes in disclosures of cash-settled swaps, potentially upending a key element of activist hedge fund strategies’ approach to campaigns, while multi-strategy, multi-PM shops could be impacted by planned curbs on pass-through expenses.
Concerns
The proposals have emerged as an increasingly live issue for the hedge fund industry in recent weeks. A survey of hedge fund managers for this report found that around 60% of North America-based firms are either ‘somewhat concerned’ or ‘very concerned’ about the proposals, compared to 40% who are ‘not concerned’ over the proposals.
Industry participants say the SEC proposals mark a break from a predominantly disclosure-based regime, which recognises hedge fund allocators and managers as highly sophisticated investors who can freely contract the terms of their relationships, towards a more proscriptive rules-based framework governing relationships between advisors, private fund clients, and investors in the private funds.
The Managed Funds Association said in a letter to the SEC in April that the proposed rules will “fundamentally alter the fruitful, longstanding relationships” between private funds and their sophisticated investors, and warned of “unintended costs associated with the proposals.”
One of the major planks of the mooted reforms centres around the prohibition of pass-through expenses, such as fees or expenses associated with regulatory examinations or investigations, or for regulatory and compliance expenses of the investment manager.
Large multi-strategy hedge fund firms, which typically have different portfolio management teams, often have high fixed costs. Instead of having a normal asset-based management fee, their economic model tends to reduce or eliminate management fees, instead passing through management company expenses onto clients.
“If passed as proposed, managers that utilise a full pass-through expense model would likely have to build in some sort of flat asset-based charge to pick that up,” Nicholas Miller, partner at Seward & Kissel, tells Hedgeweek. “This strikes at the heart of the business model and the economic relationship that these managers have set out with their private fund clients and which investors have signed on to.”
‘Smother’
Another key focal point for the hedge fund industry relates to proposed new SEC disclosure requirements for investors with a 5% stake or more in public issuers in the US. Under the planned reforms, certain hedge funds and other asset managers will need to include their holdings of cash-settled derivatives towards the 5% threshold if the derivatives are held with the purpose of influencing the control of the issuer of the reference security.
“Requiring such managers to include cash-settled derivatives towards their beneficial ownership, such that they have to report them, makes it much harder for them to build an effective stake such that it would be worthwhile for them to actually wage the campaign in the first place,” Miller says.
The rule change is expected to have a major impact on those hedge funds running activist-type strategies – often considered to play a vital role in markets and the process of price discovery, rooting out fraud and driving efficiencies – who build up large positions in companies, but often delay reporting.
Richard Zabel, general counsel and chief legal counsel of Elliott Management, Paul Singer’s activist hedge fund giant, believes the SEC’s plans would “effectively smother activism” in US capital markets.
“Proposed Rule 10B-1’s mandated next-day disclosure of cash-settled security-based swap transactions would severely impair the ability of activist investors to catalyse positive change at companies,” Zabel wrote in a letter to the SEC in March. “We are mystified as to why the Commission, charged with the protection of investors and the promotion of efficiency, competition and capital formation, has proposed rules that would impair the ability of activists to spark healthy debate and create long-term value for all shareholders.”
Miller says: “The challenge facing large activist managers is that the moment they disclose their positions, the market moves. Anything that minimises their activities will have some costs and impact on the market.”
Barrier
Elsewhere, the implosion last year of Archegos Capital Management, which dealt hefty losses to prime brokerage businesses run by Credit Suisse and Nomura, forms the basis for planned new amendments to the SEC’s Form PF rules relating to systemic risk and market stability.
While the US watchdog sees the proposed reporting requirements as enhancing systemic risk assessment and investor protection efforts, particularly during periods of market volatility and stress, hedge fund industry trade groups are pushing back.
The MFA believes that imposing costs on large hedge fund advisers would raise the barrier to entry for new hedge fund advisers, eliminate new entrants and decrease competition in the marketplace.
The Alternative Investment Management Association meanwhile believes data collection and analysis needs to be improved in order to justify reporting requirements, adding that the reporting of certain key events could exacerbate a crisis.
“Asking for real-time, ex-ante information in a manner that will impose significant operational and compliance burdens on private fund advisers is not justified by the desire to have such information for ex-post outreach, examinations or investigations and that submissions of this information on a longer deadline would not affect the value of the information for those purposes,” Jiří Król, AIMA’s deputy CEO and global head of government affairs, wrote in a letter to the SEC.
Other SEC proposals stem from the perennially-thorny issue of fees, and the perception among investors that hedge funds have long charged high fees for often patchy performances, despite industry data showing fees have steadily come down over the past decade.
“Some of the private fund advisor rules would prohibit certain types of preferential treatment, and then they would require extremely detailed and granular disclosure on others,
“The SEC’s proposals would require much more significant and granular disclosure on preferential treatment, even down to disclosing what the actual fee rate and fee break is that you’re giving people,” says Miller.
‘Critical’
So what next? While the reforms remain at an initial proposal stage, compliance experts believe they provide an informative guide as to the US regulator’s overall direction of travel.
“At the end of the day, these are still only proposed rules, but that doesn’t mean you can ignore them,” observes Miller. “In the day-to-day, to the extent that you’re doing something that comes within the ambit of these proposals, it is useful to see this as a reference guide to better understand how the SEC is thinking about these issues.”
Pointing to the “significant industry push-back”, he continues: “Many of these proposals strike at currently accepted and highly routine matters in the private fund industry. If you fall into a bucket where these proposals would really strike at important parts of your business, think about getting engaged with an industry group, or writing comment letters or engaging in some other way.
“There is also a significant open question as to the scoping of these rules for non-US managers, both registered and unregistered, and so I think non-US managers should also be very aware of these of these proposals.”
Kavita Devani, head of compliance operations at Coremont, notes that the current regulatory proposals from the SEC are “driving one of the busiest periods in a number of years” and will impact both SEC-registered and unregistered private fund managers.
“This is going to be quite cumbersome and time-consuming for compliance departments across the US because there is just so much going on – from the short-selling disclosure rule, proposed quarterly statements for investors detailing information such as fund fees, expenses and performance and updating the beneficial ownership reporting requirements,” Devani continues.
“If all these rules come into play, it’s going to be a very, very busy time and critical to get right.”
Key Takeaways
- More than half of of US-based managers are concerned about SEC proposals to overhaul rules on private fund advisors, which industry participants fear may negatively impact certain fund strategies – particularly activist approaches – and damage client relationships
- As the SEC takes an increasingly strident approach towards regulatory oversight under chair Gary Gensler in light of calls for greater investor transparency post-Archegos, experts warn that hedge funds’ compliance teams could face a busy and time-consuming period ahead
