Stan Polit
In the highly competitive private funds space, there is rarely a moment when fund managers and institutional investors feel like a “winner” at the same time. One day this summer, both groups came close.
For nearly a year, the asset management industry had been at odds with the Securities and Exchange Commission over a new set of regulations: the Private Fund Advisers Rules . These rules represented one of the most comprehensive set of regulations for private funds since 2010’s Dodd-Frank Wall Street Reform and Consumer Protection Act. Of the many issues at stake was the fate of one of the industry’s most important negotiating tools: the “side letter,” the very vehicle by which institutional investors can exert their power and influence to extract preferential terms. These agreements are so ubiquitous that I tell new fund managers who try to avoid them that, much like laundry and taxes, side letters are a certainty of life.
The PFAR could have changed that dynamic. Not only would the rules have prevented fund managers from selectively granting liquidity and transparency rights in all but a few circumstances, but they also would have required them to disclose all “material economic rights” to investors. For a historically secretive industry, this amounted to near heresy. With so much at stake, it is not surprising that many participants in the asset management industry let out a collective sigh of relief when a federal court vacated the rules in June.
While these rules may be in the proverbial rearview mirror, a lingering question remains: Do these rules still matter? The PFAR may no longer be gospel, but it does not mean the principles behind it have gone away, and this matters for both fund managers and institutional investors alike.
The several hundred pages of ink spilled in the PFAR’s adopting release was no accident. It reflected larger trends in the way both the SEC and private fund managers view some of the thorniest issues facing alternative investing. Institutional investors seeking to maximize the value of their private fund investments must not ignore these trends. Instead, they may need to learn how to strategically navigate an investing space where the status quo may be shifting.
A Reflection of Both Past and Future Trends?
To understand why the PFAR still matters for the institutional investing community, it is important to view these rules within the context of other trends in the private funds sector. At the core of the “Preferential Treatment Rules,” which encompassed the prohibitions on selective liquidity and transparency terms, was the issue of conflicts of interest. For example, is it fair or equitable to allow an investor with more leverage to request terms in a collective investment vehicle that gives them an “edge”? While fund managers may have bristled over these rules limiting their ability to grant certain terms (and obliging them to disclose the rest), this does not mean that they had not already been concerned about the very conflict issues they tried to address.
Even before these rules had been adopted, fund managers and institutional investors alike had expended much mental (and commercial) energy determining who was granted preferential rights and on what terms. For example, on the investor side, it had been a priority to ensure that the “most favored nations” provisions in their side letters included the ability to opt into preferential liquidity terms granted to other investors. At the same time, a segment of the fund manager space had been skittish about the prospect of selectively placing certain liquidity rights in the hands of their most significant investors. Some fund managers went as far as taking the position that they would not entertain such requests—not as a commercial matter, but rather as a matter of policy.
The specter of the PFAR may lend credibility to the view of some fund managers that certain terms are so conflict-ridden that they should not be granted in side letters. While the post-PFAR regulatory space is still evolving (and may be significantly impacted by November’s election), it would not be a surprise if some of the considerations at the heart of these rules made an appearance in the SEC’s examination priorities in the future (as they had been a subject of SEC inquiry prior to their adoption). These commercial realities, combined with regulatory uncertainty, may mean that some fund managers going forward are more likely to use the principles by these rules as a “shield” against granting certain investor preferences.
Charting the Path Ahead
A post-PFAR world does not mean that the leverage held by institutional investors is gone. It just means that these investors may need to refine their approach to a quickly evolving space.
Meeting these potential challenges requires a refined approach that considers larger trends. As a threshold matter, in a world in which requests for liquidity terms may be more likely to be rejected, institutional investors may need to factor this into their due diligence review and overall risk assessment. If such terms are to be sought, these investors may consider framing these requests such that they apply to all investors, rather than just to them, specifically, due to their reputation or check size. For example, while an investor-specific notice right may be viewed as creating PFAR-esque conflicts, framing that same request as applying to all investors gets to the same goal, while eliminating some of the fiduciary-driven arguments that may make the request hard to accept.
Institutional investors subject to certain unique legal and regulatory considerations may also consider the importance of framing certain requests, to the extent applicable, as a compliance (rather than commercial) matter. Framing these requests in this way may help make such terms more palatable to fund managers, as even the PFAR provided a carveout for selective liquidity rights granted due to specific legal or regulatory needs. While not all terms lend themselves to these kinds of approaches, taking a more purpose-driven approach may set up institutional investors for greater negotiating success.
The primary legacy of these rules is uncertain. It may take several years (or more) before its full impact is realized. 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 the path ahead in the private funds market.
Stan Polit is a partner in the financial markets and funds group at Katten Muchin Rosenman LLP. 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 matters.
This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of ISS STOXX or its affiliates.
Tags: PFAR, private funds, Securities and Exchange Commission, side letter, Stan Polit