The clock is ticking for RIAs to adapt to the SEC’s Private Fund Advisers Rules, the most demanding of which will go into effect later this year and early in 2025.
According to compliance consultants, advisors need to start preparing for stringent quarterly reporting requirements for private funds that will become fully effective next March.
The SEC rolled out its Private Fund Advisers Rule package in August 2023 to improve transparency and eliminate conflicts of interest among fund administrators. The number of private funds in the U.S. market has increased recently. By mid-year 2023, there were 47,443 such funds, with 3,798 advisors advising them, an increase of almost 27% from the first quarter of 2021, according to the SEC. U.S.-based individual investors were the beneficial owners of 9.6% of the aggregate NAV of these funds. When announcing the Private Fund Advisers Rule, SEC Chair Gary Gensler noted that the package was being advanced “on behalf of all investors—big or small, institutional or retail, sophisticated or not.”
Requiring quarterly reports, for instance, shows LPs exactly how much they are paying for their funds’ performance, “and it’s probably more than they thought,” said Igor Rozenblit, managing partner of Iron Road Partners, a New York City-based compliance consulting firm.
Getting approval from their compliance department is already one of the top challenges facing RIAs investing in illiquid alternatives, second only to lack of liquidity, according to a recent survey by market research firm Fuse Research Network. Thirty-eight percent of respondents, including 30% of RIAs and 40% of independent broker-dealers, listed it as a challenge.
In addition, a survey of alternative fund managers administered earlier this year by global fiduciary services firm Ocorian in partnership with Newgate Compliance found that 88% of respondents expected their compliance risk to increase over the next two years. The survey included over 100 executives overseeing regulation and compliance at alternative fund management firms worldwide and focused primarily on fund managers’ work with institutional clients.
“Unless an RIA is working through a platform that screens the alts manager and will verify/monitor that the investment manager has the systems and operations and vendors in place to implement and track their investment management process as promised … I am not sure how they could get comfortable with firms outside the top most well-known brands,” wrote Neil Bathon, managing partner of Fuse Research Network, in an email.
Standards Will Change
The Private Fund Advisers regulations package is currently being challenged in court by a coalition that includes the National Association of Fund Managers, the American Investment Council and the Managed Funds Association, among others. The plaintiffs argue the SEC is overstepping its authority to oversee private funds. A panel of judges from the 5th Circuit Court of Appeals heard oral arguments on the case in February. Observers expect a ruling next month, and it’s not certain the SEC will win the case, according to Rozenblit.
However, larger private fund managers are already indicating they will adopt more stringent reporting standards in some capacity, regardless of whether the SEC requires it. That means smaller RIAs that directly or indirectly advise private funds might have to follow suit to stay competitive.
In February, the Institutional Limited Partners Association, a trade group representing institutional limited partners in private equity, launched a project to improve its existing reporting templates. ILPA asked LPs, GPs, service providers and members of industry associations to join its working groups to help finalize a set of new standards by July of this year. The organization planned to start a public comment period in May.
“The SEC Private Fund Advisers Rule offers a meaningful opportunity for the industry to work together towards solutions that will satisfy needs from both LPs and regulators for greater consistency and transparency,” ILPA said in a press release.
“There is this case in front of the 5th Circuit, but in some ways, the genie is out of the bottle,” according to Rozenblit. “A lot of our clients who are larger and do not come from the RIA side are telling us that because of the spotlight, the SEC put on these issues, no matter what happens in the 5th Circuit, they will voluntarily comply with portions of the quarterly reporting rule.”
And the rule is “just a bear,’ Rozenblit noted.
“It may not sound like a significant undertaking, but it is,” said Mike Kell, senior vice president of education strategy and programs at alternative investment platform iCapital. “This is something that is a huge change to the industry. I think it’s a great thing for the end investors, but from an asset manager’s perspective and for advisors to the funds, it is something a lot of them are not used to. Even if they are doing some form of reporting, it’s maybe not at this level or subject to these very specific requirements.”
What to Prepare For
Part of the challenge affected RIAs will face is the condensed timetable for completing the quarterly reports. Reports will have to be presented to investors 45 days after the end of the quarter, except for the fourth quarter report, which will have to go out within 90 days after the end of the fiscal year. Fund-of-funds will have to present their reports within 75 days of the quarter’s end and 120 days after the end of the fiscal year.
For each of these reporting periods, affected RIAs will have to provide information on all fees and expenses charged to the fund, including the methodology for how they are calculated, a portfolio investment table that will outline all compensation paid to the advisors by the fund or allocated to them from covered portfolio investments; and data on fund performance. Liquid funds must outline cumulative net total return for the current fiscal year through the reported quarter and historical net returns for the preceding 10 years. Illiquid funds will have to provide inception-to-date gross and net IRRs, gross and net MOIC and an accounting of contributions and distributions, among other things.
Every expense charged to the fund will have to be itemized and fit under a pre-defined expense category, with no allowance made for “miscellaneous” items, according to Rozenblit. He said it will be much harder to report unexpected expenses that tend to come up during the fund’s life.
“You have to have line items for each individual type of expense,” he said. “Every line item needs to be linked to your limited partnership agreement. And every line item also needs to be linked to a specific allocation policy or methodology. That means if you don’t have one of those, you probably need one of those.”
Getting all of this in order and ready to go into reports by March 2025 will be much easier for large alternative asset managers that have been operating private funds for years and have mature compliance departments in place, noted Valerie Ruppel, head of U.S. regulatory consulting with Ocorian.
On the other hand, for retail wealth managers who only recently started offering their funds, “you have a lot of disclosure obligations you are going to have to consider,” she said. “It’s not that you can’t do it, I would just say be very mindful that there is a lot of compliance heavy lifting that goes on behind the scenes to get that program fit for purpose.”
Ruppel recommends smaller RIA shops keep an eye on how the large alternative asset managers handle the upcoming changes to quarterly reporting rules. For that purpose, the forthcoming template changes being worked on by ILPA might be worth paying attention to. Advisors can also consider hiring a compliance consultant to help them navigate the process. Another option for smaller firms that may not be able to deal with expanded compliance tasks in-house is to partner with online alternative investment platforms such as iCapital, CAIS and others, who typically help RIAs handle compliance issues through a streamlined process, according to Mike Kell.
However, among the first things everyone needs to do is build a template for the quarterly reports, according to Rozenblit. To do that, firms must examine their existing fee structures, performance data sets, leverage usage and other relevant information.
“Our clients are making their templates; they are linking them to their partnership agreements and their allocation methodologies. They are setting up their systems so that the data can be easily extracted. And they are testing them and making sure they are doing it right,” Rozenblit noted.
While getting ready to present investors with quarterly reports is a massive undertaking, it might ultimately lead to private funds becoming much more attractive to retail investors, he noted. Historically, the argument against retail investors allocating money to private vehicles was that they were very lightly regulated. If regular reporting becomes a standard industry practice, “that argument becomes less effective. This going into effect may be one of the things that could open up the private equity and hedge fund world to retail.”