The SEC’s recently ratcheted-up regulations on private funds have the asset managers running crypto versions of those vehicles parsing the potential fallout.
New rules, which took effect last week, apply to hedge, private equity and certain venture capital funds.
Among the core changes that will go into effect after 60 days: quarterly statements, as well as annual fund-level audits, plus additional mandated disclosures on fees for the benefit of investors.
Hanging in the air, though, industry participants say, has been no small measure of relief — considering the US securities’ overseer did not appear to have taken a more draconian route with its regulations, generally considered the largest rule-making overhaul on the books since the Dodd-Frank Act of 2010. The private funds industry has an estimated $17 trillion under management.
The agency, led by Chair Gary Gensler, notably did not pass a version of the regulations that would have made it substantially more straightforward for investors to sue asset managers for a range of investment breaches big or small. That measure, which was floated in earlier versions of the new regulations, would have opened up top asset managers to litigation to a deep degree.
Adam Guren, the co-founder of Hunting Hill Digital, told Blockworks that the new requirements are not all that onerous for firms that have already been above the board — and paying attention to the rule-making process as it has played out since earlier this year.
“I think, relative to what we’ve seen with proposals, what we’ve seen in previous drafts of this, it’s lighter than what we were expecting,” Guren said.
Guren, who is also chief investment officer of Hunting Hill Global Capital, said that “discussions around expenses” were gearing up “to be a pretty hot topic.” Top fund managers have often turned to what’s known as a pass-through fee structure, essentially getting limited partners to sign onto a fee system that helps the manager cover technology, trading and the like.
The SEC’s new rules did not ban that practice, though they claimed fund managers will have their firms’ fees more closely scrutinized, to go along with the fund-level annual audit requirement.
That said, the rules are set to “materially increase costs,” Guren said, especially for managers on the smaller side that may be in a worse position to weather those increases.
“It’s difficult for innovation, and small managers that are trying to grow — especially in digital assets there’s a disproportionate amount of small managers in crypto, rather than traditional hedge funds,” he said.
Gensler protecting investors ‘big or small’
SEC Commission Hester Peirce, who has pro-crypto leanings, said in prepared remarks August 23 that the new rules would harm the negotiating ability of sophisticated deep-pocketed investors, essentially leading to them paying more for the same investment prowess, the same returns.
They will “impose a retail-like framework on this very institutional marketplace,” she said, adding that the shift is primed to impose “a prescriptive regime that edges out mutually agreed upon ground rules for private funds.”
The gist of the new rules appear designed to level the playing field for investors. The old-adage SEC wisdom used to be that institutional investors could hold their own in negotiating checks written to hedge fund managers — and had the money to risk in doing so that few other investors had.
“By enhancing advisers’ transparency and integrity, we will help promote greater competition and thereby efficiency” Gensler said in a statement. “Consistent with our mission and Congressional mandate, we advance today’s rules on behalf of all investors — big or small, institutional or retail, sophisticated or not.”
Gensler has emphasized the connection between institutional limited partners and the retail investors who are tied to their pension plans and endowment products, for instance.
Side letters becoming transparent
The SEC is taking out asset manager side letters in their previous form — blocking the practice of offering one limited partner preferential treatment without opening up the option to all investors.
Side letters are typically how the largest investors, who are willing to contribute the largest sums to a fund, are able to drive down their own management or performance fees, while other investors are left pulling the full freight.
“We already disclose that we have them,” Guren said. “So, it’s not a surprise to any of our investors that they’re around. We have a few of them with our largest investors, and they predominantly focus on the most-favored terms…If an investor said, ‘Hey, look, I see that large anchor investors have these preferential treatments. We would like them.’ We say, ‘Great, you can have them if you invest at the same size.’”
By that same token of offering the same investors the same opportunity set, the regulation requires managers to ensure they’re offering equal liquidity provisions, on a time-weighted basis, to limited partners. That could come especially into play with less-liquid private equity firms that allow larger investors to liquidate part of their holdings ahead of the fund’s schedule.
Bryan Corbett, the president and chief executive of the Managed Funds Association, said in a statement that the “final rule will increase costs, undermine competition, and reduce investment opportunities for pensions, foundations, and endowments.” The Managed Funds Association (MFA) is a trade group and lobbyist for the alternative investments industry.
On the auditing front, Guren said that Hunting Hill Digital ought to be in a mostly unchanged position, given it’s one of a handful of crypto funds that is audited by EY, one of the Big 4 accounting firms. Others, sometimes for expense reasons, tend to favor auditors lesser-known on Wall Street or with the SEC.
For smaller firms, “there is no question that it’s more challenging,” Guren said. DeFi-heavy strategies may have to unwind, then rebuild, their books each quarter to comply with the position disclosures and valuations, he said.
“If you’re running a strategy that may be on multiple or dozens of exchanges, it creates more complexity,” he said. “It creates more difficulties for a staff to put together a quarterly statement, to build a book, then unwind it every quarter just for a statement — doesn’t seem like a reasonable thing to do.”
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