With the SEC’s proposed oversight rules thrown out, private markets professionals have the opportunity to change the game, instead.
Not long ago, tennis’ waning public appeal caused authorities to consider rule changes that might breathe new life into the sport. Commentators noted those considerations when watching Carlos Alcaraz at the recent Wimbledon Men’s final, where he displayed a new playing style on grass that forced his opponents to adjust their game just to keep up with him. Perhaps the rules didn’t need changing – Alcaraz was reinvigorating the sport by changing the game itself.
That logic could equally be applied to the recent debacle in the private funds arena, following the US appeals court strike down of the Securities and Exchange Commission's private market fund oversight rule. Amid industry pushback on the SEC measures by coordinated industry groups, the court determined that the SEC had overstepped its bounds by insisting on rules to “protect” sophisticated investors involved in private funds.
Forcing compliance with unsophisticated rules
The SEC’s intent to "improve" the game for investors in private markets (with rules generally intending to increase transparency and mitigate conflicts of interest) were based on principles suited for retail investors. Sophisticated investors were already protected by rules imposed on the fiduciaries investing on their behalf.
The regulator did what regulators do best: legislate imperatives that get the most direct results and answers to the information sought, and insights required. This forced compliance with arguably blunt rules within a discrete, sophisticated, self-regulated investment community.
In the public market, regulations are used to protect the weaker party, i.e. retail investors. Industry bodies, such as the Alternative Investment Management Association Limited and the Alternative Credit Council , pre-emptively cautioned the SEC that their proposed oversight rules were not only misaligned with the private markets' unique dynamics but could also lead to unintended negative consequences. Apart from an unavoidable new compliance burden, it was feared the rules could "fundamentally transform the private fund industry in ways that that will have significant unintended and adverse consequences for investors," The two groups wrote in an open letter to the SEC.
The proposed rules were also likely to significantly increase costs of investment and doing business for sophisticated, knowledgeable investors already employing expert advisors on all investor-related matters. These investors also benefit from protections under federal securities laws, including fiduciary duties owed by advisers under the Advisers Act. Circuit Judge Kurt Engelhardt rejected the SEC's argument that Congress gave it authority in this regard through the 2010 Dodd-Frank law because the latter was once again focused on public benefit considerations. He emphasized that they "ha[ve] nothing to do with private funds," which are designed for sophisticated investors.
The Alcaraz Effect: An opportunity to lead industry reform
But with the rules thrown out, the private markets have the chance to change the game themselves by evidencing the absence of so-called harmful practices through encouraging industry conduct in line with best practice standards.
For possible answers, we'd be well served to consider other jurisdictions that were faced with similar "threats" of potentially mismatched regulation. In the wake of the Global Financial Crisis in 2008 in the United Kingdom, the alternatives industry was placed under immense pressure to regulate hedge funds in line with mutual funds regulation. In response, the various UK alternative investment industry bodies – many whose international chapters were coincidentally also involved in the US appeals court strike down of the SEC's Oversight Rule(s) – embarked on an industry initiative to codify best practice standards in the UK, as an alternative to the regulator codifying prescriptive industry rules for “protection” purposes.
In addition to more focused industry guidelines, market representatives could simply reconcile the "SEC's wish-list" to advisers' pre-existing fiduciary duties under federal laws, within the existing parameters of industry practice and protocols and with a renewed focus on industry best practice,. Market participants can set out to reach a consensus on what conduct best solves the real industry needs.
What does this mean in practice? If private fund players support this alternative to blunt regulatory rules, enforcement and costly compliance, participants must invest in processes and systems that support the industry best practices with respect to access to information, fair treatment of investors, and equitable transactional processes — and most importantly a means to record and evidence these actions in an auditable process.
One of the most overlooked yet critical functions is the complex process of private funds contracting as part of primary and secondary transactions. The efficiency and effectiveness of the transaction process within an auditable process can significantly affect a company's ability to evidence self-regulated compliance with industry best practice and continuous information management throughout the contract lifecycle.
Achieving a scalable and responsive contracting ecosystem involves the integration of contract management technology, virtual data rooms, legal expertise and robust tracking and reporting tools, reducing the time spent in negotiations and mitigating the risks of non-compliance and disputes.
But how can this be achieved quickly?
Integrating talent, expertise and technology to change the game
By leveraging specialized legal expertise and advanced technology to transform complex transactional legal work, private fund players can elevate their contracting practices and operational efficiency through comprehensive solutions that go beyond mere document management. Such an ecosystem should offer streamlined processes for LP transfers, side letter management, and transaction support, all underpinned by an auditable framework that encompasses expertise, virtual data rooms, data tools, and knowledge artifacts — along with practical technology enablement.
This approach not only ensures compliance with industry best practices but also provides tangible evidence of fair investor treatment, adherence to fiduciary responsibilities and data-driven improvements.
The private funds industry finds itself at a crossroads. Just as Alcaraz revolutionized tennis from within, the private funds sector has an opportunity to transform itself by enhancing standards without external rule changes. By proactively embracing industry-led best practices and leveraging innovative technologies, fund managers can address regulators' concerns and drive progress, while maintaining the flexibility and sophistication that define private markets.
Innovative managed service providers are at the forefront of this transformation, offering cutting-edge solutions that enhance transparency, fairness, and efficiency in private fund operations. By adopting advanced technologies and committing to higher standards of practice, the private equity industry can proactively address issues of transparency and investor protection. This approach allows the sector to evolve and improve from within, potentially mitigating the need for disruptive regulatory intervention. These technological advancements and best practices enable fund managers to streamline operations, provide clearer reporting, and ensure equitable treatment of investors. As a result, the industry can demonstrate its commitment to self-regulation and continuous improvement, aligning with the expectations of both investors and regulators in an ever-evolving financial landscape.
Those who lead this change will not only survive but thrive, setting new standards of excellence and redefining what's possible in private market investing.
Factor designs and implements modern solutions for LP Transfers and transactional work in Private Market secondaries as well as contracting operations for a wide range of documentation, including Joinders, Master Confidentiality Agreements, Release and Non-reliance Letters.
Originally published in Private Funds CFO
