A sweeping set of rules for private fund advisers adopted by the SEC in August has underscored the agency's recent turn to a more hands-on regulatory approach for private equity and has sparked industry concern over the cost of compliance.

SEC Chair Gary Gensler has articulated a broader mandate for the agency in private markets, where private equity fund managers and large, sophisticated institutional investors were historically given broad latitude to hash out agreements.

In a statement issued the day of the SEC's 3-2 vote in favor of enhanced reporting requirements and investor protections, Gensler's view extended beyond institutional investors to their millions of beneficiaries — "municipal workers, teachers, firefighters, professors, students and more" who have entrusted pension funds and college endowments, for example, with their retirement savings.

That may seem like a subtle shift in perspective by the SEC, but it is an "earthquake" for private markets, said Farrell Fritz attorney Alon Kapen. The change prompted a lawsuit by industry trade groups that argued the agency overstepped its authority, crafting rules that will erode returns and reduce competition.

"If the SEC is trying to protect the investors here, an unintended consequence is that they are sticking it to them, because the additional compliance costs are going to be passed down," Kapen said.

'Less bite than anticipated'

Highlights of the rules package include new quarterly reporting requirements for fund advisers that aim to shine a light on fund fees, expenses and performance metrics. Fund managers will now be required to disclose any preferential terms granted to one investor — via bespoke agreements known as side letters — to all other investors in a fund.

The SEC made several concessions to fund managers in the final rules, ultimately allowing some activities it originally proposed to prohibit, as long as they are disclosed to investors.

"There's a great deal of consternation about the new regulatory regime. But on the other hand, there's a little bit of relief that the final rules are not quite as burdensome as originally proposed," Kapen said.

Ongoing concerns

The concessions have not quelled industry concerns that increased compliance costs will squeeze fund returns. From an accounting perspective, the rules are likely to lead to a significant increase in activity, said Werner Barnard, chief growth officer for consulting firm Sapro.

Higher costs could weigh heavily on small and emerging managers that have to disperse the burden across a smaller pool of investors, said Michael Wolitzer, a partner at law firm Simpson Thacher & Bartlett LLP. Less established fund managers could struggle to gain a foothold in private equity or even be forced out, limiting competition and ultimately reducing choice for investors.

Wolitzer said fund managers also must step carefully as they interpret the SEC rules, which are in a 660-page document. The agency, for instance, will allow fund managers to grant preferential terms to certain investors in a fund only if they do not have a "material negative effect" on other investors. Until the agency offers additional guidance, that is a judgement call for the fund adviser.

"The industry, with these rules, is in a vulnerable spot, and it will be hard to know with certainty that you're on the right side," Wolitzer said.

Shifting general partner-limited partner dynamics

Concerns that the new rules could increase expenses for funds and eat into returns were not unfounded, said Neal Prunier, senior director of industry affairs for the Institutional Ltd. Partners Association (ILPA), a trade group representing private equity investors. But "with where the final rule landed, a significant component of that is reduced, if not eliminated," Prunier said.

There "is some disingenuousness" in the way industry groups have described the threat the rules pose to small and emerging managers, Prunier said. Some of the enhanced reporting requirements amount to a "click of a button" for fund managers that already provide quarterly updates to investors.

ILPA, notably, has not joined the industry lawsuit challenging the rules as an unlawful expansion of SEC authority. ILPA's members, even with their investment sophistication and access to expert legal and financial advice, could benefit from the agency taking a more active role in private markets, Prunier said.

"You can be a sophisticated investor and still not drive terms the way you should anticipate, given the market dynamics," Prunier said.

Investors who participated in ILPA surveys were nearly unanimous in the belief that fund managers, known as general partners (GPs), held more leverage when negotiating the limited partner (LP) agreements that set the terms for investing in private equity funds, Prunier said.

"We have seen the dynamics of the industry shift significantly toward the GP's favor."

SEC's broader agenda

The rules adopted in August were not the first move by Gensler's SEC in private markets. In May, the agency required faster and more frequent reporting of certain adverse fund events through what is known as a Form PF, a change that raised similar concerns about the costs of compliance and increased scrutiny of private markets.

Slated for finalization in October are new rules requiring private funds to adopt cybersecurity policies and disclose more information on cybersecurity risks and incidents to both investors and the SEC.

The agency this summer also proposed broad rules governing the use of predictive data analytics, or tools that apply statistical analysis to historical data to predict the future behavior of markets and investors, a rule that could also have implications for private markets participants, according to lawyers at Simpson Thacher & Bartlett.

Kapen said the SEC's emphasis will continue to be more regulation — "more enforcement rather than kind of the more traditional approach of the SEC, which is disclosure."