SEC Approves New Regulations for Private Equity Funds and Hedge Funds, Putting a Tight Rein on the Over $25 Trillion Market!

On Wednesday, August 23rd, the U.S. Securities and Exchange Commission (SEC) approved a set of new rules with a 3-2 vote, aiming to completely reform the way private equity and hedge funds interact with investors. This represents the biggest regulatory challenge faced by companies such as Blackstone and Apollo Global Management in over a decade. These funds manage over $25 trillion in assets, including many pension plans, university endowments, and funds established by wealthy individuals.

These rules restrict the ability of private equity and hedge funds to attract large investors by offering them more favorable terms (known as side letters) than other investors. The SEC will also require private funds to provide investors with detailed quarterly financial reports on their performance and expenses, as well as undergo annual audits.

SEC Chairman Gary Gensler stated:

The core of these new rules is to address some of the opacity issues in this field. Investors of all sizes benefit from increased transparency.

Certain parts of the rules that were ultimately approved have been relaxed compared to last year's proposal. Nevertheless, this new regulation still represents a significant regulatory push in the hedge fund industry, which has long been accustomed to minimal government oversight. Gensler noted that loose regulation and low interest rates have allowed private funds to surpass the commercial banking industry in size over the past decade, earning hundreds of billions of dollars in fees annually.

Two Republican commissioners of the SEC voted against these rules, questioning whether the agency has the legal authority to impose stricter regulations on private funds.

Commissioner Hester Peirce stated:

The formulation of these new rules is unreasonable, unlawful, impractical, confusing, and harmful.

For over a year, the hedge fund industry has been trying to resist these regulations. These funds have accused the SEC of attempting to interfere in complex contractual relationships and have hinted at the possibility of filing lawsuits to overturn these rules before they are finalized.

Bryan Corbett, CEO of the Investment Adviser Association, expressed concerns that these rules "will increase costs, disrupt competition, and reduce investment opportunities" for hedge funds. However, the Investment Adviser Association stated that the final rules are "overall more reasonable" compared to the SEC's proposal last year.

Pension funds and other institutional investors typically allocate some funds to private funds in order to outperform publicly traded stocks and mutual funds. The SEC traditionally considers these investors to be sophisticated enough to fend for themselves in the market, and private funds face less regulation than the mutual funds available to ordinary investors.

Industry officials have expressed difficulty in persuading Gensler, who is known for advocating for aggressive regulatory reforms. SEC records show that representatives from hedge funds, private equity firms, and venture capital funds have held over thirty meetings with SEC officials in the 18 months since the agency proposed these rules, and they have also lobbied members of Congress against the agency's plans.

One of the biggest sticking points for private fund managers is the SEC's proposal to ban certain side letters. Industry insiders argue that such agreements help facilitate transactions with large investors, whose presence enhances the credibility of the funds. The final version of the SEC rules softened some of the language regarding the addendum. The initial proposal required asset management companies to disclose the fund's addendum to all investors before completing the transaction; the final rule only requires them to disclose addendums involving "significant economic terms."

Unless the asset manager provides these terms to all other investors in the fund, they will be prohibited from providing certain investors with special redemption rights or information regarding the fund's holdings.

The SEC abandoned plans to prohibit fund managers from charging fees for poor service and to limit their own misconduct or negligence liability in the final version of the rules. Smaller funds will also have more time to comply with these changes compared to larger funds, and some new restrictions will not apply to funds established before the rules take effect.

Some industry institutions have expressed that the SEC's new rules represent progress, but still leave private fund investors vulnerable to misconduct.