Stan Pollitt
In the highly competitive private funds space, there are very few moments when fund managers and institutional investors feel like they are “winners” at the same time. One day this summer, both groups approached each other.
The asset management industry has been at odds with the Securities and Exchange Commission for nearly a year over a new regulation, the Private Fund Advisor Rule. These rules constitute one of the most comprehensive sets of regulations for private funds since the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Among the many issues at stake is the fate of “side letters,” one of the industry’s most important negotiating tools, a means by which institutional investors can exert power and influence to extract preferential terms. It was its own destiny. These agreements are so widespread that I tell new fund managers who try to avoid them that side letters are a certainty in life, like laundry or taxes.
PFAR may have changed that trend. The rules not only prohibit fund managers from selectively granting liquidity and transparency rights, except in a few circumstances, but also require them to disclose all “material economic rights” to investors. This will likely be required of fund managers. For a historically secretive industry, this was almost heresy. With so much at stake, it’s no wonder that many in the asset management industry breathed a collective sigh of relief when a federal court struck down the rule in June.
These rules may be in the proverbial rearview mirror, but questions still remain. “Are these rules still important?” PFAR may no longer be gospel, but the principles behind it are not gone, and this is equally important to fund managers and institutional investors alike.
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It is no coincidence that hundreds of pages of ink were spilled on PFAR’s adoption release. This reflects a larger trend in how both the SEC and private fund managers view some of the most vexing issues facing alternative investments. Institutional investors looking to maximize the value of their private fund investments should not ignore these trends. Instead, you may need to learn how to strategically navigate an investment space where the status quo is changing.
Does it reflect both past and future trends?
To understand why PFAR remains important to the institutional investor community, it is important to view these rules in the context of other trends in the private funds sector. Conflicts of interest were at the heart of the “preferential provisions,” which included prohibitions on selective liquidity and transparency conditions. For example, is it fair or just to allow investors with greater leverage to demand terms that give them an “advantage” in a collective investment vehicle? While they may have been outraged by these rules limiting their ability (and requiring disclosure of remaining conditions), this does not mean they were not already concerned about the very conflict issues they were trying to address.
Even before these rules were adopted, fund managers and institutional investors alike spent a lot of mental (and commercial) energy deciding who to give priority to and on what terms. I was there. For example, on the investor side, a priority was to ensure that the “most-favoured nation” clause in the side letter included the ability to opt-in to preferential liquidity terms granted to other investors. At the same time, some in the fund manager industry were cautious about the prospect of selectively handing certain liquidity rights into the hands of the most important investors. Some fund managers have even taken the position that they will not comply with such requests, as a matter of policy rather than a commercial matter.
The specter of PFAR may lend credence to the view of some fund managers that certain conditions are so contradictory that they should not be allowed in side letters. Although the post-PFAR regulatory field is still evolving (and likely to be significantly affected by the November election), it is likely that some of the core considerations of these rules will emerge as SEC review priorities in the future. That’s not surprising (as they were the subject of an SEC investigation prior to their adoption). These commercial realities, coupled with regulatory uncertainties, may lead some fund managers to use the principles of these rules as a “shield” against granting certain preferential treatment to investors in the future. may mean an increase in
chart the future path
A post-PFAR world does not mean that institutional investors no longer have leverage. It just means these investors may need to refine their approach to a rapidly evolving field.
Addressing these potential challenges requires sophisticated approaches that consider larger trends. As a reference point, in a world where requests for liquidity conditions are more likely to be rejected, institutional investors may need to factor this into their due diligence reviews and overall risk assessments. If such conditions are required, these investors should ensure that these requirements apply to all investors, and not specifically to themselves, based on their reputation or the size of their check. You might consider building a . For example, investor-specific notification rights could be seen as creating a PFAR-like conflict, but structuring the same requirements as applying to all investors can accomplish the same goal while Eliminates some of the fiduciary-driven arguments that can make claims difficult. To accept.
Institutional investors, who are subject to certain unique legal and regulatory considerations, may also consider the importance of framing certain requests as compliance (rather than commercial) matters, to the extent applicable. Framing these requirements in this way is important because even the PFAR provides for carve-outs of selective liquidity rights that are granted depending on specific legal or regulatory needs, such that such conditions may help make it more palatable to fund managers. While not all conditions are suitable for this type of approach, a more purposeful approach may help institutional investors negotiate more successfully.
The primary impact of these rules is unknown. It may take several years (or more) for the full effects to be felt. While it is impossible to clearly read the ‘tea leaves’ and predict the future, using the past and present as a guide may be the best way to chart a path forward in the private funds market.
Stan Polit is a partner in Katten Muchin Rosenman LLP’s Financial Markets and Funds Group. His practice focuses on helping U.S. and international financial institutions, including private fund managers and institutional investors, navigate complex domestic and cross-border transactional and regulatory issues.
This feature provides general information only, does not constitute legal or tax advice, and may not be used as a substitute for or for legal or tax advice. you can’t. The opinions of the authors do not necessarily reflect the position of ISS STOXX or its affiliates.
Tags: PFAR, Private Funds, Securities and Exchange Commission, Side Letter, Stan Pollitt
