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- Reflections on the Demise of the SEC’s Private Fund Adviser Rules: LP and GP Perspectives
In this episode, Nossaman's Yuliya Oryol and guests Chris Hayes and Jason Mulvihill provide LP and GP perspectives on the SEC’s Private Fund Adviser Rule. Chris and Jason were deeply involved with the proposed Rule – one worked with ILPA on behalf of the LP community to lobby the SEC to adopt the Rule in order to help institutional investors in their negotiations with GPs, while the other worked with the AIC on behalf of the GP community and was instrumental in expressing GP objections and opposition to the Rule and developing the successful litigation to challenge to the Rule.
After extensive advocacy by the Institutional Limited Partners Association (ILPA) and others on behalf of the Limited Partner (LP) community in support of stronger regulation of private funds, the Securities and Exchange Commission (SEC) adopted the Private Fund Adviser Rule (Rule) on August 23, 2023. The Rule consisted of five new rules: the Private Fund Audit Rule, the Quarterly Statements Rule, the Restricted Activities Rule, the Adviser-Led Secondaries Rule and the Preferential Treatment Rule, plus two rule amendments addressing annual compliance documentation and retentions of books and records.
However, on June 5, 2024, a three-judge panel of the U.S. Court of Appeals for the Fifth Circuit, unanimously vacated the Rule. The Fifth Circuit held that the SEC exceeded its statutory rulemaking authority under the Investment Advisers Act of 1940 in adopting the Rule. The SEC could have asked for a rehearing en banc in the Fifth Circuit or it could have appealed the decision to the U.S. Supreme Court. Instead, the SEC determined not to do anything further to ensure survival of the Rule. As a result, the Rule is dead - at least for now and the foreseeable future.
Transcript: Reflections on the Demise of the SEC’s Private Fund Adviser Rules | LP and GP Perspectives
0:00:00.0 Yuliya Oryol: Welcome to another episode of Pensions, Benefits and Investments Briefings. My name is Yuliya Oryol. I'm a partner at Nossaman and Co-chair of the Firm's Pensions Benefits & Investments Practice Group. For over 25 years my legal practice is focused exclusively on the investor side and public and private market transactions. The majority of the practice group's clients are public pension systems and other institutional investors who invest in private funds as limited partners or LPs. This episode will provide our listeners with LP and GP perspectives on the SEC's Private Fund Adviser Rules. The rule would have imposed significant new compliance and regulatory requirements on private fund advisors. The rule is actually five new rules, the private fund audit rule, the quarterly statements rule, the restricted activities rule, the advisor led secondaries rule and the preferential treatment rule plus two rule amendments addressing annual compliance documentation and retention of books and records.
0:01:05.8 YO: The private fund adviser rule was adopted by the SEC on August 23rd, 2023. Not surprisingly, it was challenged by the GP community and on June 5th, 2024, a three judge panel of the US Court of Appeals for the Fifth Circuit unanimously vacated the private fund adviser rule. The Fifth Circuit held that the SEC exceeded in statutory rulemaking authority under the Investment Advisers Act of 1940 and adopting the rule. The SEC declined to request a rehearing and bunk at the Fifth Circuit, and it also did not appeal the Fifth Circuit's decision to the US Supreme Court. In fact, the SEC had until early September, 2024 to do so, and the deadline has now passed. The SEC said that it's proud of the rule and the benefits it would have conferred to the investors and private funds. It also stated that the agency has made a strategic decision to focus its resources on adopting and implementing other items on its rulemaking agenda.
0:02:10.7 YO: It indicated that it was disappointed with the Fifth Circuit's decision, and I know many LPs including Nossaman clients are disappointed as well. Today, we will gain insight from two experts who are deeply involved with the proposed rule. Our speakers are Jason Mulvihill and Chris Hayes. Jason is the founder and president of Capital Asset Strategies. He previously served for 12 years as the General Counsel, head of Government Affairs and Chief Operating Officer of the American Investment Council, AIC, which represents the leading private equity and private credit GPs. Jason's role at AIC included leading the GP engagement with legislatures and regulators. He developed the AIC successful litigation strategy on the SEC private fund advisers rule, and was instrumental in supporting the GPs in their efforts to challenge the rule. Jason is joined by Chris Hayes, his business partner, who serves as the managing partner of Capital Asset Strategies.
0:03:10.5 YO: Chris led the policy and legal best practices efforts as the head of policy at the Institutional Limited Partners Association, ILPA from 2017 to 2022. ILPA represents over 650 institutional LPs invested in private funds globally. Chris spearheaded the legislative and regulatory efforts at ILPA to achieve the policy changes that resulted in the SEC private funds advisers rule. Chris also previously served as general counsel at the Small Investor Alliance, working on behalf of middle market GPs. Their firm Capital Asset Strategies is a policy and regulatory consulting firm that provides bespoke government relations, regulatory guidance, due diligence and strategic engagement services to clients in the financial services and digital asset industries.
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0:04:13.5 SI: Welcome to Pensions, Benefits & Investments briefings, Nossaman's podcast, exploring the legal issues impacting governmental, private and nonprofit pension systems and their boards.
0:04:35.2 YO: I am really excited to speak with Chris and Jason today and to hear their unique perspectives, reflections on lessons learned, as well as discuss with them their thoughts on how institutional investors and private fund advisers should move forward in their interactions and negotiations of private fund terms. Given what has happened with the rule, I think we should start first with Chris to discuss the reasons why this rulemaking came about. Chris, can you share with us a little bit about the origin of the SEC private fund adviser rule and also ILPA's role in pushing for reforms to the investment advisers act?
0:05:10.9 Chris Hayes: Sure. Thanks Yuliya, and thanks for having me here along with Jason. Many people maybe don't understand a little bit of the history here before the private fund adviser rule was proposed and there's a little bit of history before that happened, and it really starts with sort of ILPA's role in representing its LP members. So, I think when many folks who work at ILPA, including myself, sort of thought about ILPA's role of helping LPs, it's really about how do we help our members achieve higher returns in the alternate investment space, particularly private equity, and achieve that with sort of less downside risk. Whether that's in terms transparency, governance, et cetera, in the fund agreements in particular. And my role there was really at the forefront of two of those items, which really around best practices, which is essentially encouraging all of ILPA's members to push for certain standards certain minimum standards around transparency, governance, alignment of interest in their fund agreements and the idea being that representing a large number of folks in the market will result in a meaningful improvement in the fund terms that all LPs will be able to receive small or large in the marketplace.
0:06:19.2 CH: And the advocacy work was really the other end of the coin, which is really about how do we ensure that the SEC continues to have sort of oversight over the managers that LPs are investing in to make sure that we have someone looking over the shield of GPs where maybe we don't have the particular information access or specific rights to access that information and that we have service someone keeping them, making sure they're following the rules and following the fund agreement in addition to ourselves. And then also thinking about, how do we potentially push forward to achieve a certain number of required standards in the investment advisers act, which governs these managers, which were given capital to. And for a long time when I joined ILPA, we were in sort of a defensive node trying to prevent rollbacks to SEC oversight of these funds.
0:07:12.3 CH: And we were pretty successful in doing that because we thought, the SEC's roles was important and certain rules that touched the investment contract were critical, and there were various legislative items to kind of remove the registration requirement or roll back some of the rules under the registration requirement. And we were successful in defeating those. Somewhere along the way, after many conversations with, particularly in-house legal counsel at LPs, external legal counsel like yourself, Yuliya, there's sort of a consistent concern about some of the provisions of the terms, and much of those really revolved around transparency and governance terms. So fiduciary duty provisions, having to negotiate to receive the ILPA fee template, for example, other sort of basic things that we thought were basic minimum standards. And so the idea sort of developed to think about how could we essentially go to improve the market for LPs through making some of these requirements mandatory in the fund agreement or requiring that, fee and expense reporting information would have to be acquired rather than requested in the negotiation process.
0:08:13.5 CH: And so originally that idea really took the shape of a legislative effort, and we tried around 2019 to try and move that forward, but it was sort of overshadowed by other actors in the political space that wanted to go much further than ILPA did. In terms of, we were seeking some pretty modest reforms around some of the items I just mentioned. We had a draft legislation called the Investment Adviser Alignment Act that we tried to move forward, but it was overshadowed by efforts by Congress to move something that was much more holistic that included many provisions that we actually thought would prevent LPs from receiving the returns from the investment in the first place and went a bit further. And so that sort of sucked a lot of the air out of the sales of us to move that forward. And ultimately the legislative strategy was not really potentially achievable.
0:09:02.9 CH: And so we started thinking about other ways in which we could encourage some movement on these issues. In addition to continuing our best practices work with LPs, continuing to organize LPs to try and negotiate as a group to get better results in their fund agreements. And obviously this was also a time where it was a bit more of a seller's market in the private fund space. We saw an opportunity when the Biden administration came into power that there might be a more amenable SEC to doing some of these things through rulemaking where we believe they had some existing authority to do these things, but also would be limited on how far they could go to not do the things that we thought were problematic. And obviously when you ask government to do anything, what comes out of it is a bit imperfect, but kind of that just kind of goes with the territory of, using a blunt instrument to solve some of these problems.
0:09:53.1 CH: And so after many efforts of educating, talking to the SEC, talking to folks in Congress about these issues, we were excited to see that chair Gensler at the SEC had taken on these positions and was interested in doing something which ultimately resulted in the private fund adviser rule that we saw come out and be proposed in 2022. Right, actually before I left ILPA. And so that is really sort of why these rules came about, because there was some political support to do that with the new staff and leadership at the SEC. There was a lot of education that was done from the LP and ILPA perspective about some of the challenges in the marketplace, particularly around negotiating fund agreements and concerns that we had heard repeatedly from our members, predominantly on the legal teams at LPs in their outside legal counsel about the significant slip in terms that we had seen since the global financial crisis.
0:10:48.3 CH: And this was really an effort to try and attack this from a different angle. That's really, I think from the ILPA perspective, from the LP perspective, where many of the rule kind of came from, and I think many people aren't fully aware of maybe that effort and why that happened, which was something that was actually, brought to the ILPA board and they thought it was an effort that we should look at trying to advance forward. And I think actually LPs were somewhat surprised that it was achieved and was proposed. And so that maybe resulted in sort of the LP perspective on the rule in being sort of surprised that this rule had had popped up.
0:11:23.7 YO: No, I totally agree with you Chris. Many LPs were surprised how it played out and hopeful, really hopeful that there would be some change as a result of rules with the way LPs and GPs interact. But I'm curious what Jason thinks about what has come down and if he could share out his experience from the GP perspective on how the GP community responded to ILPA's efforts in Congress and at the SEC.
0:11:50.9 Ason Mulvihill: Happy to Yuliya and again thanks again for allowing me to join this conversation. I think to contextualize the objections to the rule from GPs, I think it's important to start off with the fact that GPs view LP/GP cooperation and the fund investment negotiations as really the best way to work out contractual differences and preferences among sophisticated parties, all represented by sophisticated counsel. If an LP does not like the terms it's getting for prospective investment in one of the funds, it has many other options of funds to invest in. And many other GPs with proven track records will be willing to negotiate with them. The LP has a lot more leverage in this process than many who were pushing for this rule were prepared to fully acknowledge. And I think the basic relationship between LPs and GPs over the long term that has been obtained through negotiation has been very, very productive for LPs.
0:12:41.6 AM: For most of the last 40 years, private equity has been the best performing asset class for defined benefit pension plans, insurance companies, university endowments, sovereign wealth funds, and many other sovereign sophisticated investors. The system works well overall, and if it isn't broke as the saying goes, don't fix it. I think it's also probably relevant to note that the battles over increasing regulation of the LP/GP relationship have, as Chris pointed out, taken on many forms over the past 10 years. Some of it had perhaps been driven by a regulator who wanted more power, even if not authorized by Congress. Over time, I think GPs had expressed objections to various pieces of extreme legislation on this topic. Chris had sort of alluded to some of the proposals like the Stop Wall Street Looting Act and the Draft Investment Adviser Alignment Act. Those bills did not advance and GPs have also actively engaged with the SEC throughout this time.
0:13:40.8 AM: When the SEC clarified standard of conduct for investment advisers and their fiduciary duties in 2019, 2020, we spent a very active time engaging with the SEC there. And we know that there were some efforts to try to change obligations to sort of reflect contractual preferences in that process. As the saying goes, obviously elections have consequences and Chair Gensler and his team, I think it would be fair to say were very skeptical from the word go about the private equity business model. Some would say they were downright hostile to it, and GPs, I think realized and understood in this environment that they would have to tell, their side of the story in Congress and that the regulators, even though we all realized that the SEC under chair Gensler had an agenda in mind on this topic from the start. So in addition, we had to try to keep the regulators educated and honest about the practical challenges of their proposal.
0:14:35.0 AM: We filed extensive comment letters that highlighted the many substantive flaws with the proposal, and we were pleased that several former SEC commissioners, chairman and chief economists from both Democratic and Republican run SECs had expressed serious concerns about the proposal and the failures of the economic analyses that accompanied the rule. Many members of Congress, including leaders from the Congressional Black Caucus, also expressed concern about the slip shot economic analysis that underlaid the rule and of its perhaps unintended consequences, particularly for smaller firms and minority run firms. GPs, I think, recognized in the context of this fight that they had to preserve the option to litigate against the rule if it was as extreme as it turned out to be. And they did so. When the final rule was released the decision to pursue litigation, I think was clear for a lot of people because of the lack of legislative authority to do what the SEC was doing.
0:15:35.0 AM: And secondarily because the Administrative Procedure Act has requirements, and I think there was a strong consensus amongst many legal community that the APA at least in regards to this rule, there were several violations at play. And so from a GPs perspective, the Fifth Circuit directly determined that the SEC lacked congressional authority to make the rule. Congress does not hide elephants in mouse holes as the saying goes. And the court did not even have to reach the APA issues raised in the rule because the lack of statutory authority. So, to sum up this fight was a marathon and not a sprint. And I think GPs stayed focused on obtaining the right policy outcome throughout. With all of that said, I think GPs remain as open and excited as they always are to work and find creative solutions for LPs to ensure that LPs are happy to invest along with them in growing and strengthening businesses throughout the economy.
0:16:35.2 YO: Thanks, Jason. As someone who represents exclusively LPs, I think it's fair to say that the majority of my clients supported the rule, at least they support some regulation to help their negotiations with GPs. I do have to admit that some LPs had mixed feelings about the rules, and they were concerned that perhaps the rule may hurt their ability to negotiate side letters, especially for the public pension systems who regularly negotiate side letters because there was a proposal on restricting preferential treatment, and as you alluded Jason to the cost of enforcement and the possibility that it would leave some players, some GPs out of a market because it would make it too expensive for them to participate, maybe such as emerging managers who couldn't afford the back office operational costs involved.
0:17:29.7 YO: I'm curious to see what you, Jason, and also Chris, think about why LPs had mixed feelings about the rule, and particularly from Chris, I would be interested in hearing about what you heard from the LP community in terms of the support. Would the result have been different if the LPs perhaps more vigorously supported the proposal, perhaps the divide between the investment staff and legal staff and some institutional investor communities also caused issues with the rule? So I'm just curious to discuss what you both think about how this rule could have played out differently if there was more support from the business and the legal community behind it.
0:18:11.6 CH: As many LPs know, the LP world is sort of a big tent. You obviously have a very diverse membership ILPA, but you also have a diverse group of LPs generally, right? All sorts of different types of institutions, different motivations, different commercial models engaging in this marketplace, all competing for allocation with specific managers. And then you have different views among those leaders, whether they're investment staff or legal staff, whether they're enmeshed in the terms, whether they're at an organization that is achieving the terms it wants in its side letters or strategic arrangements with managers or not. And all of that I think really comes into play with, how the engagement on the private fund advisor rule came out. Touching on a few of those items, I think, first and foremost sort of education, right? So when this rule came out, first of all, it was sort of unexpected as we mentioned before. And I think even though we were engaging on it, it was sort of a surprise that this was actually going to happen and that actually the regulatory environment for product funds could change. That sort of created some anxiety in the LP community, right? So a lot of LPs by nature are somewhat risk averse to changes in the market. And as you pointed out they're concerned about, hey, how will I invest in the future?
0:19:33.9 CH: How will this impact my access to managers? How will this impact my ability to deliver to my beneficiaries, wherever they might be, and sort of my return profiles and risk profiles? And will I get the same deal that I've been getting and expecting to get, depending on my institution size and influence in the market? And I think this will obviously present a significant amount of uncertainty to market participants and LPs about what that market would look like once the rule came into force, particularly, as you noted, the preferential treatment provisions where many LPs were sort of exerting their energies to achieve the results they wanted. And the reason those provisions were put in the rule was really a result of sort of this belief that the SEC had about that a rising tide would lift all boats, and that essentially, the terms in the agreement would be improved by larger LPs using their negotiation power to improve the overall document. And that negotiation power had been diluted by side letters so that smaller LPs would not achieve the benefits in the fund agreement. And we can discuss whether that's actually true in the market or not, but that was really the rationale, really backed up by a lot of the academic research that the SEC was relying upon.
0:20:50.7 CH: And ILPA's membership is made up of a wide variety of large and small members. Large members who maybe are achieving a lot of what they wanted to achieve in the side letters or through particular strategic partnerships across multiple funds with GPs, and what were the implications for that? And smaller LPs who maybe would achieve more economic insights and information access than they would have previously, which really gets at some of the challenges we had seen around fund term transparency in the market, given that all these fund agreements are secret documents. And so I think that was certainly a driver of that anxiety and a division between large and small LPs. Overall, I think, as you noted, most LPs were supportive, at least from some of the polling I had seen, but larger LPs, I think, potentially had a bit more trepidation in the space. There's also individuals, right? So individuals who lead these organizations on the investment side may have different views about government regulation, and those are valid views, right? So when you think about, we have registered funds that solves a lot of the problems this rule addressed, and there's a reason we moved away from registered funds due to their cost and inefficiency and inability to do certain investment strategies to private funds.
0:22:02.2 CH: And the question is, how much regulation should be on a private fund? And ultimately, LPs pay the cost of that regulatory compliance. And what is the right balance of government involvement in this space? And I think there's a lot of different views with people's different political views, et cetera, investment views about that. And then lastly, I think there's a relationship aspect to this, right? So many LPs, particularly on the investment side, are having more regular interaction with their peers who are partners at GPs, and they have good personal relationships. And they say, "Look, I really like working with this particular GP. We're in a partnership together. I feel really confident." And I think this dynamic actually spreads more broadly in the industry beyond just these rules that, "Hey, I consider the LPA really a break the glass quote type document," and the terms are less important here.
0:22:47.3 CH: Whereas if you think about legal teams at LPs, and I think there's a real divide between legal and investment teams, and LPs should be thinking about how to bridge that divide and make sure there's more sharing of information. Legal teams are solely focused on the fund agreement and thinking about the downside risk of the terms in the agreement. Whereas I investment folks are more focused on this firm can generate X return and, okay, if I have to take some risk here on the downside side, I'm less concerned about that because the upside I'm getting. And I think one of the fundamental challenges that we've seen, particularly among data, is the ability for that fund agreement and what those terms mean and the downside risk of those terms to be considered more upfront when the investment decision is being made in particular LP organizations.
0:23:32.5 CH: And so I think all of those things resulted in a mixed reaction to the rule, which blunted the ability for ILPA or others to be effective, vigorous champions of the rule. For good or worse, obviously, there's a lot of concerns about those rules, and maybe that's okay. There were a variety of efforts that ILPA did do to obviously educate its members, which I thought was great. Obviously, organized letters to support it with a number of institutions signing on themselves, which I actually thought took a lot of courage for many LPs.
0:24:05.4 CH: It's always challenging to get LPs to sign on to those letters, given their concerns about alienating their GP partners and risking their allocations for supporting that regulatory change. And so I think that sort of shows why you had this mixed reaction. And that mixed reaction, I think, did a couple of things politically. First, you had an SEC and leaders of the SEC who sort of expected LPs to come out vigorously support the rule, and they were expecting that, and they didn't get the vigorous support that they expected. So that challenged some of the relationships with the agency and with folks on the Democratic side of the aisle that maybe would be more supportive of LP positions now and in the future. I think the second element that it impacted was GPs felt that LPs were divided, and therefore, it allowed them to more effectively challenge the rule, because they were able to point out that many LPs didn't like it either.
0:25:02.0 CH: And I'll note that the GPs had taken a pretty broad set of ideas into that rule proposal that was much more broad than even LPs had anticipated or asked for. And so that created its own concerns. So I think all of those elements are sort of why we saw the response we did and why we saw maybe GPs feel more comfortable with such a vigorous response. But obviously, Jason would know more about that.
0:25:27.5 AM: I'm happy to weigh in just for a few minutes. I know we have a couple of other questions. But to me, I think the mixed review that the rule received from LPs sort of underscored both the sorcerer's apprentice problem with running to the SEC to try to get contractual preferences enacted into law, and also, funnily enough, the benefits that negotiations between sophisticated parties yield. I mean, every LP is different, just like every GP is different. And a lot of times, LPs have very unique demands and issues that they need to resolve when they're going to make an investment.
0:26:01.4 AM: And I think, frankly, over time, sure, I'm sure there's counsel on both the LP side and the GP side that are not always thrilled with how one particular provision or an LPA comes out or another. But overall, the parties reach an agreement, or if they don't, LPs are under no obligation to invest with a particular GP. And that's as it should be. And I think sort of what happened was, I think that sort of the process that played out here, and I think the understandable concern that some LPs expressed about, you know, wondering, well, is this really what they were hoping for? And might they end up living in a reality that's actually worse than being able to sort of negotiate freely with other sophisticated parties for investment, and rather than being sort of restrained by a government mandate that the SEC didn't even have statutory authority to enforce. So, again, I think at the end of the day, the fact that there was some LP disagreement on parts of the rule is just indicative of the fact that it's very difficult to get government and sort of, kind of parse different provisions of a contract. And it's probably not the way government should be involved.
0:27:16.4 YO: Jason, do you think that the GP community sees the LPs as not being united in general? And does that play to their advantage in negotiating with LPs?
0:27:28.2 AM: I don't know that I would make a broad statement on that one way or the other. I will say this, that obviously, every time a GP raises a new fund, they negotiate, often extensively, with a wide variety of LPs who come to the table with different investment goals, different objectives, and also different on the legal side, different provisions that they care about for a wide variety of reasons. And I think by and large, LPs and GPs are willing to sort of negotiate and hash out and work in good faith to try to find, a solution that will encourage an LP to invest in a particular fund and the GP to have confidence that when they manage that fund and direct that fund, that it will yield great results for the LP and for the businesses in which they invest. So I don't know that GPs, every GP is different too. It's not like every GP is a carbon copy of the other. And I think just the nature of the types of investing that you're doing here, which is not retail investing, right? This is sort of sophisticated investing in illiquid assets in operational businesses over a long time window, sometimes three, five to seven, eight, nine years, depending on the business.
0:28:38.1 AM: I think it needs a relationship that's governed by contract that where there can be some consensus that's reached after sophisticated parties negotiate in good faith. And so I think from a GP perspective, I think most GPs would say it's better to negotiate in good faith with your sophisticated investors rather than have to sort of fit into a straitjacket that looks an awful lot like a RICS, but not allowing those LPs or GPs to contract to their specific concerns.
0:29:09.7 YO: Chris, I want to start with you and I afterwards would like to hear Jason's thoughts on this point as well. Do you think there was a chance that the rule proposal did not push forward on so many different issues or relied on different legal authorities? It might not have been challenged or struck down on litigation. I mean, what do you think the results would be for future rulemaking or legislation in this area?
0:29:31.7 CH: I think what's unique about the rule is it relied on a never tested provision in Dodd-Frank that appears sort of clear on its face that it would allow the SEC to have this authority, but had not exercised before, but was in a section that was really focused on retail investors. And I think it really was up to the particular circuit, obviously in this case, the Fifth Circuit, which is generally skeptical of agency rulemaking in general. So you would expect them to have a particular perspective on this. So I think if the rule had been brought in a different jurisdiction, a different circuit, perhaps the court could have interpreted it differently. I think that's possible. Although obviously the challenge was designed to be brought in the Fifth Circuit. I think if the rule was not so thorough, covering so many different issues, I do think there's the potential that the GP community might have accepted the rule. So for example, if you had just pushed forward on the fee template where many, I think the data was about 62% or something was the data we had of adoption by GPs in the market about the OPLA fee template.
0:30:42.2 CH: If the fee reporting and performance reporting requirements had been the only thing in that rule, perhaps the GP community would have been okay with that because they would have felt, "Hey, are you doing some of this already? Maybe it's not worth challenging it, upsetting our LPs," et cetera. And so I do think if the rule had been proposed with less items in it, potentially it might have moved forward without a litigation challenge. And secondly, if it had relied on not this new authority, although I'm not actually sure what other authority they would have had to be able to use, they did rely on older authority and rule 206, which also wasn't effective in the Fifth Circuit. So I'm not sure that would have made a difference, but perhaps the rule might've moved forward without a litigation challenge by the GP community, or it would have not been struck down, or you might've had more LP general support for it if it had not, for instance, included the side letter preferential treatment provisions. So in terms of where this might go in the future, I actually think this has really shut down any opportunities, right? So as we pointed out, legislative efforts have not been generally successful to move forward any kind of changes here in the rule.
0:31:51.2 CH: And I actually think the court decision will further erode any ability to do that. And I think the SEC in the future has been really under fire for a lot of its rulemaking initiatives in the courts. It's not a friendly Supreme Court to agency rulemaking, particularly given the recent removal of Chevron deference. So I don't see any kind of legislative or regulatory movement in the future here, unless there's some sort of financial crisis where there's a large financial services regulatory reform type bill where these provisions would be inserted somehow. That's the only thing I could see that might move it forward, but it's unclear sort of when or if that might even happen. And so I think where you're going to see most of the movement here is sort of enforcement examination activities by the SEC going forward, as opposed to rulemaking, and then any kind of industry related initiatives like that ILPA or the private funds community might come up with from a commercial perspective.
0:32:54.1 YO: Jason, what are your thoughts on this?
0:32:56.2 AM: Yeah, I think the SEC lacked the authority to do this rule as the Fifth Circuit decided. And I don't think that removing parts of the rule would have solved that fundamental threshold problem for the SEC. And Congress had been clear for a long time before this rule, including after Dodd-Frank, that the fundamental differences between the way RICs were regulated and so-called 3C1, 3C7 funds were regulated, were different and were to be maintained. So even when after Dodd-Frank, most private fund advisors were required to register with the SEC, that same division was maintained. And I think just by removing one part of the proposal wouldn't have made all of the other parts all of a sudden magically get an authority that was acceptable and passed muster with the courts. I think the fact that the SEC had to rely on 211H, and then on sort of very, very broad, general anti-fraud sort of catch-all language highlights the fact that they didn't have good legal authority to pursue the rule. And they were sort of grasping at straws a bit, or perhaps grasping at straws is the wrong analogy.
0:34:11.1 AM: I think the SEC swung for the fences in an unauthorized power grab on this issue, and they missed. And the consequences of that error, to Chris's point, are not trivial, particularly in a post-Chevron deference era ushered in by the Supreme Court's recent Loper-Bright decision, and at a time when the SEC's ALJ system, Administrative Law Judge system, has also been invalidated by the court, and the JFSC decision. I think it's very hard to see how the SEC could have prevailed, even if they had taken this case to a different circuit, or even if it wasn't brought in the Fifth Circuit. And so I think there's some long-term consequences there. I think one of the positive ones is the SEC has to follow the law just like everyone else, including all their regulated entities. And I think that's a good reminder here for the agency that, probably their rules will have to be a little more closely linked to actual congressional authorization than they may have been in the past. And to the extent there is legislation that comes about to make changes, whatever that legislation is, it's probably going to have to be more expressed and detailed, and granting regulators express authority, including the SEC, if they want the SEC to do X, Y, or Z. Chris makes a very good point that, it doesn't look like in the near future there will be opportunity for legislation in the space. I don't see that ripening any time soon either.
0:35:39.0 AM: That said, I think it's always important to remember that in 2006, after the Goldstein decision, the DC Circuit struck down the SEC's registration requirements for hedge fund advisors. And as a practical matter, a number of years later, Dodd-Frank imposed registration requirements for most private fund advisors. And so, over time, I think it's true that legislation, could be a way you can see further amendments, but obviously there's no clear path at this time that would suggest that that's in the offing anytime soon, and what will shake it up. So, I think at the end of the day, the court made the right decision. I think the SEC was sort of going through an exercise of expressing its policy preferences for what they wanted to do with private funds with this rule. And unfortunately for them, they just lacked the authority to do it. And the court reminded them of that fact.
0:36:40.3 YO: Well, Chris, if all of that is true, how do you think the LP community moves forward from this rule? I mean, what happens with ILPA and with the rule itself? I mean, given your experience, what do you think of the best practices initiatives that ILPA worked so hard to implement, such as the templates that we worked on together on the LPA and the subscription agreement templates and all its other efforts? What do you think will happen with all those initiatives and do they continue pushing the GP community in other ways since they can't do that now through the SEC?
0:37:19.1 CH: And I think one thing that's fundamentally changed since the rule was proposed is really the market environment. So the higher rate environment that we've seen since the rule was proposed in 2022 has changed the fundraising dynamics, I think, in the private fund market, thereby giving maybe LPs more leverage than they might have had previously. Although, of course, I'm not the one negotiating these documents. That's my sense is that the fundraising market has tightened in certain places. And that does give more ability to maybe move forward with best practices standards, unlike during the time between the global financial crisis and the post-COVID rate increases. So I think the market dynamics are a pretty important element that maybe gives some of these best practices efforts, including ILPA obviously has put out for comment its new updates to the fee template, which I think are a bit more tailored and more engaged and have taken some feedback out of what the SEC rules have done. And so they're continuing to hopefully move those forward. I also think LPs can think more about how to standardize things. I think one of the biggest challenges in the best practices space was really GPs were on board, I think, with some of these best practices elements, if it was sort of a standard document that they could print out.
0:38:39.5 CH: I think the problem was essentially many folks wanted the standard reporting, but then they also wanted bespoke reporting on top of that, which really negated the economic value for GPs to sign up for standard. And we sort of expected if the rule had come into force by the SEC that some of that standardization would have occurred because everybody would be required to put out a basic minimum standard, and maybe that would have created more efficiencies in the space. And so I still think that remains to be seen. The other thing I think LPs can think about outside the regulatory arena is really trying to do more around a couple of initiatives that we worked on at ILPA. One was really around trying to help smaller LPs group together, sort of, and I know, Yulia, we've had a number of conversations about this with California pensions and folks like this, about how do we get LPs to do sort of group purchasing, group, smaller LPs banding together in a way that's antitrust compliant to allow them to write larger cheques to managers and then receive better terms in the fund agreement. And more of those sort of efforts, which are challenging given that many LPs are competitors for allocation, but maybe the market dynamics have shifted a bit since we last tried this, are efforts that I think are worthwhile.
0:39:57.1 CH: There's also some new emerging technology, and we explored this when I was at ILPA, around fund terms and in sort of how do we kind of understand what's market and promote more transparency about what terms are market in these fund agreements over time so that LPs can be better equipped in negotiating, and then also LP legal counsel can be bringing forth concerns about fund terms earlier in the investment process with GPs. And so, if the lawyer at the pension can bring in, hey, you know, just like the investment team will bring in what the projected great returns from this fund will be, and the legal team can bring in, okay, here's where I see the problems in the fund agreement at the time the investment decision is made rather than six to eight months later when they're looking at the fund agreement and that decision's already been made, you're presenting a more holistic picture so that LP leaders, CIOs, heads of PE can make those decisions having all the information up front rather than more thinking about it from an investment perspective. And then if there's problems in the fund agreement later on, it's very hard to sort of reverse that decision or raise those issues to stop moving forward.
0:41:11.2 CH: And so, I think there's some technological tools that are out there with some of these various vendors that hopefully could sort of digitize those fund agreements and create a data set of fund terms. Now, I think, many of those providers, unfortunately, have been gobbled up by larger platforms lately and maybe aren't providing as much of that service or less interest in providing that service, but hopefully some other players sort of pop up and can do that. But I think that's really the way that ILPA and other LPs can kind of continue to move the ball forward to improve sort of their downside risk in these fund agreements and achieve some better results.
0:41:52.1 YO: Thanks, Chris. And Jason, given what you heard today from Chris and myself and the discussion about some of the concerns that the LP community has had in the past and the reasons for ILPA's advocacy on behalf of LPs in changing some of the practices, do you think the rule and the recent elevation of these issues will result in any meaningful changes in the market and GP practices, perhaps?
0:42:20.5 AM: Well, I certainly think the industry, GP side, LP side as well, are going to remain engaged going forward on all of this. I think, first and foremost, GPs remain focused on continuing to deliver the impressive returns, net of any fees and carry to LPs, and LPs are going to likely, going to continue to invest robustly in the asset class, because overall, despite certain provisional questions with different legal agreements, it's a fundamentally very good deal for LPs and LPs are pleased with it.
0:42:48.2 SI: I think as before the private fund advisor rule, LPs and GPs, they're going to continue to negotiate in a system that works for both sophisticated parties, all represented by counsel. I think the ILPA template will remain very relevant as it was before PFAR. And I think Chris highlighted a very important point. I mean, I think whenever all of ILPA's members kind of get on the same page and say, look, this is how we want all of our information reported, and we don't want a bunch of additional bespoke reporting, I think that could lead to more standardization in reporting with some efficiencies for LPs and GPs de facto on both sides.
0:43:32.5 AM: But again, I suspect the market, and maybe this is not such a bad thing for LPs, I suspect that the market will stay more flexible with reporting and so that LPs ultimately will get the reasonable information they want in the form they want it, regardless of whether or not it's a standard form or not. I suspect that's sort of where it's going to go. And honestly, I think a lot of the terms that we've touched on today and that I know LPs and GPs care about are going to remain matters for contractual negotiation when there's a new fundraising going on. And I think that's as it should be.
0:44:10.2 YO: Thanks, Jason. I think to wrap up our discussion today, my own observation is that the rules will have an impact on the private fund industry. I have no doubt that ILPA will continue its involvement to advocate for LPs, and some investors, including my own clients, are already negotiating contractual terms influenced by the rules in their LPs and side letters. I do hope that the rules will serve as instructive guidelines for both the LPs and the GPs going forward. So I thank you both for this wonderful conversation today. I've learned a lot from both of you, and I appreciate your contribution to this important and evolving area. We conclude this podcast now with a big thanks to Chris and Jason for contributing to our knowledge in this important and evolving area.
0:45:00.4 YO: Thank you also to our listeners for joining us for this episode of Pensions, Benefits & Investments Briefings. For additional information on this topic and other public pension issues, please visit our website at nossaman.com. And don't forget to subscribe to Pensions, Benefits & Investments Briefings wherever you listen to podcasts so you don't miss an episode. Until next time.
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0:45:24.1 SI: Pensions, Benefits & Investments Briefings is presented by Nossaman LLP and cannot be copied or re-broadcast without consent, content reflects the personal views and opinions of the participants. The information provided in this podcast is for informational purposes only. It is not attended as legal advice and does not create the attorney-client relationship. Listeners should not act solely upon this information without seeking professional legal counsel.