Private Equity: Love It or Hate It but You Can’t Ignore It
On August 23, 2023, the Securities and Exchange Commission (“SEC”) adopted five new rules applicable to private fund advisers (“Rules”), which intend to protect investors and curtail adviser malpractices. These Rules impose certain restrictions, disclosure and consent requirements on the private fund advisers. The Rules do achieve their purpose but only to a limited extent, owing to the fact that they are highly diluted and undermined in comparison to the original proposed rules. The traditional issues that give the advisers an upper hand over the limited partners (“LPs”) / investors remain untouched. Moreover, the considerable toning down of the Rules tips the scales back in favor of the private fund advisers, and the regulators watch on as the private equity (“PE”) industry continues to devour the US economy.
The Rules in a Nutshell
The Rules impose disclosure or consent requirements (as applicable) in order to restrict allocation of adviser investigation or compliance fees to the private fund and preferential treatment to certain investors. Side letters resulting in preferential treatment to particular investors are completely prohibited if the treatment results in a material, negative effect on other investors. The Rules promote transparency between the advisers and the investors by mandating disclosure of quarterly statements with specific expenses and performance and conducting an annual audit followed by distribution of the audit report among the investors. The Rules also eliminate conflict of interest in adviser-led secondary transactions by ensuring that the investors get a fair valuation opinion issued by a professional independent opinion provider in relation to such adviser-led secondaries, along with a written summary of any material business relationship with such opinion provider.
Underlying Issues Remain Untouched
Fiduciary Liability and Charges for Unearned Compensation. Two proposed rules not adopted and involving prohibition of advisers from: (a) seeking indemnification or limiting liability for breach of fiduciary duty; and (b) charging private funds for unearned compensation, are of major relevance. Failure to adopt these rules fosters protection of advisers against bad faith negligence and overcharging malpractices conducted to increase their profits at the cost of the investors. This warrants continuation of the long-drawn battle between LPs / investors and general partners (“GPs”) / advisers, while the LPs continue with lower bargaining power on such matters (as has always been the case, historically).
Limited Scope. The quarterly statements, annual audit and adviser-led secondary aspects of the Rules do not apply to exempt private fund advisers (typically those with less than $150 million in assets under management). The exemption reduces governance over such advisers who, although forming a small part of the adviser pool, often outperform their larger peers by focusing on niche strategies. Additionally, offshore advisers who manage offshore domiciled funds are exempt from the Rules under most circumstances. Essentially, this serves as a leeway for such exempt advisers to continue to exploit the investors by overcharging and being non-transparent.
The Ticking Time Bomb
PE advisers have time and again proven to be selfish, invasive forces that continue to financialize the economy. With more than $4.5 trillion in investments, PE is now taking over our daily lives by entering every industry. Companies owned by PE face a higher risk of bankruptcy than companies that are not. In addition to financial engineering, the advisers now also play a huge role in managerial engineering of the portfolio companies to maximize their returns. Such managerial engineering largely involves changes in executives, firing employees and commercializing every service or offering of the portfolio companies at the cost of its core values. In a recent example, post the acquisition of Twitter, Elon Musk laid off about half of the company’s workers late last year.
The Way Forward
While the slash-and-burn reputation of the PE players is fading with the passing years, it still is strongly persistent in many PE firms. In order to effectively protect the investors and enforce fair PE practices, the SEC should implement stricter governance involving prohibitions on unfair practices (without qualifications), such as those that were previously proposed but not adopted. The backlash from the private fund advisers is inevitable but should be tolerated to bring the investors at parity with the advisers, giving them equal bargaining power. A non-binary environment is the need of the hour, where the benefits of the GPs and LPs are positively correlated.
Additionally, the tax regime needs to undergo alterations. The current tax treatment of carried interest as allocation of partnership profits benefits the investors heavily as they are taxed at the U.S. long-term capital gains tax rate, i.e., approximately 20 percent on the profits as “long-term capital gains,” which is approximately 17 percent lesser than the regular income tax rate. Reducing the tax preference for carried interest by increasing the tax rate, or even making it equivalent to the ordinary income tax, would promote fairness by treating individuals and businesses alike and lower the rate of adviser malpractices as lesser profits will be at stake.
While the Rules are a progressive step towards investor protection, they do not uproot the traditional issues entirely. Until more drastic measures, such as alterations of tax treatments and stricter prohibitions, are implemented, the private fund advisers will inevitably have the upper hand in partnerships. Some reporters are of the opinion that the new Rules only increase the compliance and reporting burden for advisers. This could result in a considerable amount of cost of adherence, which will eventually trickle down and get allocated to the investors themselves. A few industry groups filed a petition seeking judicial review of the Rules shortly after they were adopted, on grounds that, among other things, they exceed the SEC’s statutory authority and are arbitrary and contrary to the law. While the petition does not affect the Rules’ applicability and transition period, it will be pertinent to follow the court’s decision, and if stayed or nullified, it will wipe the slate clean, putting the investors in a more unfavorable position.
Anushka Shah is an LL.M. (Corporation Law) candidate at NYU School of Law and serves as a Graduate Editor of the NYU Journal of Law & Business. Prior to attending NYU School of Law, Anushka worked for two years as an Associate in the General Corporate (M&A and private equity) team at Shardul Amarchand Mangaldas & Co (one of India’s largest and leading law firms) at their Mumbai office. At Shardul Amarchand Mangaldas & Co, her practice largely focused on advising clients on a wide range of public and private cross-border M&A and private equity transactions dealing with industry-specific, foreign exchange and securities laws. Her role involved conducting due diligence, drafting and negotiating transaction documents, particularly in the pharmaceutical, healthcare, electric vehicles, digital and telecom sectors.