Private funds radar - July 2023

At the end of June, the SEC fined a US private equity GP $1.5m for overcharging management fees to its funds (and other connected failings). As well as paying the fine, the GP was required to reimburse the affected funds a total of $4.6m. The GP failed to exclude the cost of permanently impaired investments from the funds’ net invested capital in the particular manner required by the funds’ LPAs; in turn, this resulted in the GP overstating the funds’ net invested capital, on which the post-investment period management fee was calculated. The SEC also observed that the GP had a conflict of interest (which it had not properly disclosed to investors), because it retained discretion to determine the criteria for assessing whether an investment should be considered permanently impaired, and this directly affected the level of management fee payable to the GP. A useful reminder for all private fund sponsors to review their PPMs and ensure any actual or potential conflicts are properly disclosed.

More broadly, the SEC has been keen to emphasise to private fund sponsors that they are squarely within its focus. At the recent Securities Enforcement Forum West 2023 in San Francisco, during a keynote Q&A session, the Director of the SEC’s Division of Enforcement mentioned that the private funds industry is a “substantive priority area” for the SEC, with the SEC having particular concerns about conflicts of interest and fees and expenses.

It is against this background that the SEC recently adopted amendments to Form PF (the regulatory filing by US registered investment advisers to private funds), significantly expanding the information that GPs must report to the SEC. More information can be found in this memo by US law firm Paul, Weiss.

We are also waiting on the SEC to adopt its final private fund adviser rules. The (controversial) proposed rules were issued last year (summarised in this SEC factsheet). It is unclear how many of the original proposals will make it into the final rules, and whether the rules will apply to non-US exempt reporting advisers – we will keep an eye out for this when the final rules are published.

ILPA, the Institutional Limited Partners Association, has issued updated guidance on continuation fund transactions (a subset of GP-led secondaries), setting out a recommended approach for GPs to follow when embarking on a continuation fund process. The guidance is founded on two principles: (i) continuation funds should maximise value for existing investors; and (ii) rolling investors should be no worse off than if a transaction had not occurred. For more details, see our blog.

The FCA recently published new rules that permit the distribution of long-term asset funds (or LTAFs) to retail investors, subject to certain requirements (such as providing the investors with a summary risk warning). The new rules have been in effect since 3 July. Many private fund GPs are considering LTAF structures as a means of accessing UK retail investor capital and these new rules should facilitate that aim. See our blog for more detail.

HM Treasury has approved a series of updates to the anti-money laundering guidance produced by the JMLSG (the industry guidance designed to help regulated firms, including private fund sponsors, comply with their obligations under the UK anti-money laundering regime). Importantly, the sectoral guidance for private equity has been updated: these updates will be of relevance to all private fund sponsors, and particularly those with fund-of-funds investors.

Concerns about the regulation and oversight of private markets (and private credit in particular) are never far from the surface. In a speech to the Managed Funds Associations’ Global Summit, the chair of the FCA, Ashley Alder, gave an insight into regulators’ thinking (in short, regulators want more data on private markets, and this is likely to come from imposing increased reporting requirements on private market participants).

Negotiations on the AIFMD II proposals continue between the Commission, the Parliament and the Council. It is not clear when the final rules will be agreed (there had been hope that agreement would be reached in June, but we hear that the next stage in the negotiations has been postponed to September 2023); we understand that proposed new rules around delegation and loan origination funds, in particular, remain under discussion.

In the meantime, ESMA has issued a couple of interesting updates to its AIFMD Q&A, relating to the pre-marketing rules that came into force in August 2021. In the first update, ESMA confirmed that the rules do not apply (and thus are not available) to non-EU AIFMs, but also acknowledges that individual member states can permit non-EU AIFMs to pre-market in their territory under national law. The second update (provided not by ESMA but by the Commission) unequivocally states that the pre-marketing rules apply to fund sponsors who are not AIFMs (e.g. who may be delegated portfolio managers or investment advisers, with another entity performing the AIFM role).

The second update also included a new statement from the Commission relating to the calculation of leverage in real estate funds. In particular, the Commission explicitly stated that the “private equity exemption” in article 6(3) of the AIFMD Level 2 regulation does not apply to real estate funds (as a reminder, this is the exemption that allows an AIFM to disregard leverage incurred by portfolio companies when calculating fund leverage (as long as that leverage is non-recourse to the fund)), and that leverage incurred by entities (e.g. SPVs or investment holding vehicles) controlled by a real estate fund should be included in the fund’s leverage calculation, albeit only if that leverage directly or indirectly increases the fund’s exposure.

In better news for EU/UK relations, the two parties have agreed an MoU on financial services cooperation. While unlikely to have an immediate impact on private fund sponsors, it may lead to more joined-up EU/UK regulatory initiatives in the future, including relating to potential regulatory arbitrage. However, no sign of any mutuality on entity passporting, marketing or mutual product recognition, nor do we expect any.

The European Supervisory Authorities (ESAs) published, through ESMA, a Progress Report on Greenwashing. The report is important because it defines greenwashing, displays the regulators’ intention to enforce on sustainability-related matters, and outlines the areas in which the ESAs believe that current regulations might need to change. See our note for more details, which also considers some of the parallel regulatory advances on greenwashing in the UK.

SFDR (the EU sustainable finance disclosure regulation) is one of the key planks of the current EU ESG regime that private fund sponsors must navigate. But SFDR poses particular challenges for real estate funds. As a result, a working group comprising three industry bodies (AREF, INREV and IPF) has issued a solutions paper to address the challenges real estate GPs face in applying SFDR to real estate investments. Read our thoughts on this.

The Financial Action Task Force (FATF) has confirmed that the Cayman Islands has satisfied all the FATF Recommended Actions. As a result, the Cayman Islands will be able to be removed from the FATF “monitoring list” (also referred to as the “grey list”) later this year. In turn, this should enable the Cayman Islands to be removed from the EU and UK lists of “high-risk third countries”, easing AML/KYC friction for GPs with Cayman fund structures.