On June 5, 2024, the US Fifth Circuit Court of Appeals (the Fifth Circuit) released its decision in National Association of Private Fund Managers vs. Securities and Exchange Commission (the SEC). In a unanimous 3-0 ruling, the Fifth Circuit vacated in full the SEC’s Private Fund Advisers Rule (the PFAR), intended to give investors more protection and visibility into private funds. With this, fund managers will not be required to provide annual financial statement audits, nor to provide certain disclosures within the quarterly statements on fund advisor compensation, fees, expenses and performance. Further, fund managers will now be able to provide some investors with preferential redemptions treatment and special access for portfolio holdings.

While the ruling is seen as a victory for fund managers, many of whom had criticized the increased costs associated with the enhanced regulatory requirements proposed within the PFAR, investors will now, conversely, have less transparency on fees and terms as the requirement for the provision of certain disclosure in the quarterly reporting and annual financial statement audits falls away. Without the backdrop of an enhanced regulatory and reporting framework, now more than ever, investors will need to double down on their own fund-related legal and financial due diligence. Investors need to know, for example, if private jet travel, in-house legal expenses, and no step down in management fee post initial term is the 'norm'. As an extension of this, gaining a real understanding of what is market standard for the limited partnership agreement (LPA) fees and terms will be key in empowering fund negotiations and building in the necessary investor protections into the legal documents.

In line with this, Jennifer Choi, CEO of ILPA, expressed concern that the ruling meant that 'private funds will be under no obligation to provide critical information related to the fees and expenses charged to fund investors and meaningful performance information, leaving LPs to negotiate for terms that should be common-sense.'


Background to PFAR

In February 2022, the SEC first proposed a body of new rules aimed at bringing enhanced transparency and protection to private fund investors, as well as improving competition and efficiency in the private funds market. Following an extended comment period, the PFAR was adopted on 23 August 2023, to 'enhance the regulation of private fund advisers and update the existing compliance rule that applies to all investment advisers.'

As well as requiring every SEC-registered adviser to provide documented, written annual compliance policy reviews, the PFAR also included:

  • The Quarterly Statement Rule: Required SEC-registered investment advisers to provide certain disclosures regarding fees, expenses, performance, and adviser compensation in quarterly statements to fund investors.

  • The Mandatory Audit Rule: Required SEC-registered investment advisers to obtain a financial statement audit of each advised private fund.

  • The Restricted Activities Rule: Prohibited advisers from engaging in certain activities with respect to a private fund unless they provided specified disclosure, and, in some cases, with the requirement to obtain investor consent. An example of this was allocating expenses to investors on a non-pro-rata basis without proper notice.

  • The Preferential Treatment Rule: Required all investment advisers to make certain disclosures of preferential terms offered to prospective and current investors and, subject to certain exemptions, prohibit advisers from providing certain types of preferential treatment that would have a material, negative effect on other investors.


Strike down of PFAR and where now?

On June 5, 2024, the Fifth Circuit struck down the PFAR on the basis that the SEC exceeded its statutory authority. The SEC relied on Sections 206(4) and 211(h) of the Advisers Act, citing changes made to Section 211(h) by the Dodd-Frank Act as augmenting their rule-making competence. The Fifth Circuit rejected this position, holding that neither section granted the SEC such authority.

In reacting to the ruling, ILPA expressed disappointment that the court 'did not acknowledge the SEC’s longstanding authority to protect private market investors.'

Without the requirements for certain disclosures in the quarterly reporting and annual financial statement audits, investors must now face up to the prospect of returning to a regime where transparency and protections around fund fees and terms are limited. The avenue the SEC decides to pursue next will, however, effectively determine the reporting landscape in the long term: The SEC’s options include:

  • petitioning the Supreme Court to consider the case;

  • requesting the Fifth Circuit to review the case en banc, which would involve all active justices of the circuit reviewing the case;

  • bringing forward reduced or amended proposals based on PFAR; or

  • abandoning PFAR altogether.

If the Supreme Court were to grant the petition to review, it seems unlikely that a decision would be forthcoming for at least 12 months.


Impact on investors

While investors wait for further decisions or actions to be taken to enhance the regulatory and reporting framework, investors will need to redouble their own fund-related legal and financial due diligence efforts. They will need to know, for example, about potential ad hoc expenses, or whether the lack of a step down in management fees after the initial term is normal practice. On the latter point, within a benchmarked set of funds, 21% of funds did not specify the point at which management fees were no longer payable, while 5.6% provided that management fees were payable during the 'term' of the fund but the definition of 'term' did not specify if this included term extensions, according to Preqin's Term Intelligence. This may mean the investor unwittingly consents to paying management fees during any extensions, as the fund manager may argue that extensions were included by default within the term of the fund.

Gaining a real understanding of what is market standard for the LPA fees and terms will therefor be key to empowering investors in fund negotiations and building the necessary investor protections into the legal documents.

Preqin is here to assist investors in determining what represents market standard for LPA fees and term.


About
Heather Heys is VP, Legal Insights at Preqin, and Michael Gallagher is a Senior Associate, Legal Insights at Preqin.


The opinions and facts included in the above do not constitute investment advice. Professional advice should be sought before making any investment or other decisions. Preqin accepts no liability for any decisions taken in relation to the above.