Asset managers face tighter SEC regulation

ARTICLE | November 01, 2023

Authored by RSM US LLP

Recent rulemaking from the U.S. Securities and Exchange Commission continues to be very focused on the asset management sector. Industry trade groups argue that some of the agency’s recent regulations could significantly hamper the economics of private fund advisers, a $26.6 trillion sector within the financial services ecosystem.

Since Chair Gary Gensler took office in 2021, the SEC has proposed 53 new rules, with about 20 of them aimed at expanding the agency’s regulation of asset managers. Private funds and their advisers play a crucial role in our financial markets as assets under management have more than doubled in the past decade to $26.6 trillion in 2022 from $9.8 trillion in 2012, according to SEC filings.

Similarly, the number of private funds has increased to 100,947 in 2022 from 31,717 in 2012.

A failure within this sector would be far reaching in the U.S. economy and affect millions of Americans. The question at hand is whether the SEC’s rulemaking will effectively reduce systematic risk within the asset management space or increase the resources investment advisers and corresponding stakeholders must expend to operate without adding value to investors.

Recent rules that have drawn the most criticism from the industry include the private fund adviser rules and the enhanced ESG reporting rules. Both rules substantially increase compliance not only for registered fund advisers but also for exempt fund advisers. The private fund adviser rules seek to expand the regulation of private funds in a way not seen since the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which followed the financial crisis of 2007-2008.

The industry has responded to both scenarios by stating that the SEC is overreaching and does not have the authority to issue these rules. Industry trade groups filed lawsuits over the private fund adviser rules less than two weeks after they were passed as final by the SEC. As of early September, Bloomberg analysts anticipate those lawsuits have a 70% chance of winning.

The case for additional regulation

Americans may have financial exposure to private fund advisers, whether they are aware or not, through their participation in pension plans, endowments, foundations, and other retirement accounts. Many pension plans and endowments invest in private funds to diversify their holdings and provide increased returns to stakeholders. According to the U.S. Census Bureau, 13% of the asset allocation for state and local pensions in 2022 was invested in private equity. Given the broad reach of these private fund advisers, one of the primary goals of expanded regulation is to reduce the chances of a system collapse.

Additional disclosure and reporting requirements are intended to provide investors with streamlined data that is easily digestible and comparable. When an investor receives financial information in a standardized format calculated through widely accepted and used methods, it is easier to effectively make informed financial decisions without expending additional personal resources. Expanded disclosures on items such as fees and preferential treatment can enable an investor to use this data and demand updated terms. If the adviser does not comply, the investor can potentially pull their capital and re-invest in a different fund. On the other hand, if investors keep their capital in a fund due to preferential terms and these preferences are no longer available, they may be inclined to invest their capital elsewhere. The enhanced transparency and disclosures ultimately create better informed investors.

The case against regulation

The popular industry standpoint is that additional regulation increases costs, which decreases investors’ returns without providing additional risk protection. The agency acknowledged that its private fund adviser rules would increase compliance costs and decrease revenues. Specifically, it estimated that regulated entities would spend 3.7 million internal company hours annually, when adding up individual workers’ time, to comply with the new rule. Monetary expenses would top about $5.4 billion per year, stemming from having to provide standardized disclosures, obtaining required investor consent, refraining from restricted activities and acquiring the required external financial statement audit and fairness opinions or valuation opinions.

In general, many large asset managers are already complying with most of the provisions included in the new private fund rules. The additional burden will disproportionately impact the emerging managers or those with smaller AUM. In today’s high interest rate environment where asset managers are struggling to increase returns to investors, this cost would further damage all stakeholders with minimal, if any, value provided. Based on the SEC’s and the industry’s estimate of additional costs, it would not be surprising if the cost to operate would become too high for the smaller players with fewer resources, driving them out of business and further consolidating the industry.

Furthermore, to provide capital to a private fund adviser, one must be considered an “accredited investor.” An accredited investor is financially savvy, or has sufficient resources, to understand the risks associated with investing in private funds. As such, additional paperwork may not enhance their investment decisions, but it will cost them more time and money.

Challenges ahead

Historically, the federal courts and the industry have deferred to the SEC as the authority when it comes to financial regulation. Challenging the SEC was not as common a few years ago; thus, the SEC’s decisions on a range of regulatory topics were held as the final law. However, that tide has been changing in the past couple of years. The assertiveness of the SEC’s rulemaking has led powerful industry groups to fight back through the court system.

Recently, federal courts appear to have disagreed with regulatory decisions made by the SEC. Take, for instance, the recent case of Grayscale Investments, LLC v. Securities and Exchange Commission. In June 2022, the SEC had denied the cryptocurrency asset manager’s application to convert its Grayscale Bitcoin Trust into a bitcoin spot exchange-traded fund.  The U.S. Court of Appeals – D.C. Circuit, ruled in favor of cryptocurrency asset manager Grayscale, and reversed the SEC’s denial, calling it “arbitrary and capricious.”

The SEC’s final private fund adviser rules were adopted Aug. 23, 2023, and nine days later, industry trade groups filed a joint lawsuit. In this lawsuit, filed by the National Association of Private Fund Managers, Alternative Investment Management Association LTD., American Investment Council, Loan Syndications and Trading Association, Managed Funds Association, and National Venture Capital Association v. Securities and Exchange Commission, the petitioners claim that “the rules exceed the Commission's statutory authority, were adopted without compliance with notice-and-comment requirements, and are otherwise arbitrary, capricious, an abuse of discretion, and contrary to law, all in violation of the Administrative Procedure Act, 5 U.S.C. § 706, and of the Commission’s heightened obligation to consider its rules’ effects on “efficiency, competition, and capital formation,” 15 U.S.C. § 80b-2(c).” The petitioners claim that the SEC is relying on a general anti-fraud provision of the investment advisers Act and a statutory section of Dodd-Frank that is focused on retail investors, not private fund investors.

There are many stakeholders directly and indirectly affected by this regulatory battle, but there is not yet an obvious victor or path forward for all. In the meantime, asset managers should review their current policies and disclosure statements to assess where compliance gaps exist and how to best address them.