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A regular briefing for the alternative asset management industry.
When it comes to the regulation of alternative asset managers, Europe and the US have – until now – been on parallel paths. Since the financial crisis, regulators have argued that private capital fund sponsors should not be exempt from regulatory oversight; on the contrary, their view has been that rules are needed to protect investors, the financial system, and even the real economy. Although private equity and similar strategies did not cause or contribute to the global financial crisis – and although most investors in such funds are sophisticated institutions – legislators on both slides of the Atlantic have brought forward extensive regulations.
These reforms have had a different emphasis and impact. In the EU, the Alternative Investment Fund Managers Directive (AIFMD) is highly prescriptive. It includes an extensive rules-based regime, affecting reporting to regulators, investors and other stakeholders, fund marketing, sponsor governance, safekeeping and valuation, as well as imposing demanding capital requirements. The AIFMD even seeks to regulate capital maintenance in underlying portfolio companies.
The US reform – the 2010 Dodd Frank Act – was less ambitious. It eliminated the private fund adviser exemption, bringing most US private fund advisers within the SEC's supervisory authority for the first time, and included some specific regulatory measures. But the SEC wanted to do more, and its recent Private Fund Adviser rules, first proposed in 2022, would have somewhat levelled the playing field – going even further in some important respects.
But now – while the EU has been pressing on, although more cautiously than before – an appeals court in New Orleans has forced the US regulator into a U-turn.
AIFMD 2 confirmed the EU's intent to stick with its much-criticised post-crisis regulatory framework. Generally hailing the 2011 reforms as a success, European lawmakers layered on some new requirements, for example, on costs and fee disclosures, while adapting the rulebook to take account of loan origination funds – a strategy whose rise has been meteoric over the last decade. This week's results in the European Parliament elections, delivering the expected boost to politicians on the right, might complicate the process of passing implementing rules, but a wholesale rollback is not on the cards (at least, not yet ...).
On the other hand, the SEC's attempt to use its powers to dramatically increase the regulatory burden on registered fund advisers was put on hold last week by a unanimous verdict of the US Court of Appeals for the Fifth Circuit. The court said the Dodd Frank Act only authorised limited and specific regulation of private funds. They found that one specific section of the Advisers Act, added in 2010 and relied on by the SEC as the source of its rulemaking power, only gave the SEC authority so far as retail investors were concerned. The court also said that the SEC had failed to reach the threshold needed to make rules under its pre-2010 anti-fraud powers, noting that a registered investment adviser owes fiduciary duties to the fund and not to underlying investors.
The SEC could appeal the ruling, and is steadfast in its view that the rules are needed, but the Fifth Circuit court's views on the limits of the SEC's statutory power, and the current composition of the Supreme Court, will make further rulemaking difficult. Many think that an appeal is unlikely to succeed and is not without risk for the SEC, so it may now focus on enforcement of existing rules, rather than bringing forward new ones.
This decision will be a welcome reprieve for US sponsors, many of whom were busy preparing. The final private fund adviser rule would have added some very significant regulations, many of which are not commonly found in the negotiated limited partnership agreements and side letters that govern the relationship between a sponsor and its investors. Among the more demanding of these rules was a requirement for quarterly reporting, annual audit, and restrictions on "preferential treatment" for certain fund investors.
The SEC could appeal the ruling, ... but the Fifth Circuit court's views on the limits of the SEC's statutory power, and the current composition of the Supreme Court, will make further rulemaking difficult.
As it happens, many European fund managers – even those with a significant American investor base – would not have been caught by these rules: the SEC had already conceded (in response to lobbying by European industry associations, including the BVCA), that most of the rules would not apply to non-US managers managing non-US funds.
But the proposed SEC rule may yet have consequences despite its annulment. A related project, ILPA's Quarterly Reporting Standards Initiative (QRSI), which seeks to define the periodic reports that a sponsor should issue to investors, will continue. The investors' association remains of the view that the "lack of transparency, conflicts of interest, and the lack of effective internal governance mechanisms to protect the capital managed by private funds" means that the work of the QRSI (which involves LPs, GPs and service providers) should continue. Having recently issued an updated Reporting Template and a new ILPA Performance and Cash Flows Template for comment, ILPA has now paused the comment period while it adjusts the documents, taking advantage of the opportunity to make the templates more industry-focused – removing some of the requirements that were there only because the SEC was planning to mandate them, and which some LPs did not want.
Although take up to date is far from universal, especially in Europe, some LPs may push more GPs to adopt the ILPA templates voluntarily – joining the many sponsors who have already contractually committed to use them. That means these updates may have even more far-reaching impacts than the SEC's proposed rule, affecting fund sponsors who would have been out of scope.
So, even if the regulatory paths have now diverged in the US and the EU, investors themselves might once again take centre stage in both regions in defining their requirements – and, many would argue, that is exactly how it should be.
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