Part One: Regulatory Background and Private Funds Today
Loyola University Chicago School of Law, JD 2025
Securities and Exchange Commission (SEC) Chair, Gary Gensler, has introduced more regulatory proposals impacting market participants than former SEC Chair, Mary Schapiro, did in the same time frame following the Great Recession almost fifteen years ago. The SEC has formally adopted 22 of 47 regulatory proposals since 2021, and in August released extensive final rules targeting private funds. The new regulations in part require private fund advisors to increase disclosure to their investors regarding fees, expenses, and other terms of their relationship. Other new rules prohibit preferential treatment of some investors that may materially affect other investors in the same fund.
Wall Street has taken note. Coalitions representing the largest private funds in the country sued the SEC in Federal court in September to block the new rules. The suit claims that the SEC has overstepped its statutory authority to regulate private fund advisors and that the new rules will quash a thriving and entrepreneurial industry worth trillions of dollars.
The new rules amend the Investment Advisors Act of 1940 (Advisors Act), passed unanimously by Congress under then-President Franklin Roosevelt as the bookend on nearly a decade of securities regulation following the Great Depression. The Advisors Act regulated those who, for a fee, advised pension funds, endowments, other institutional investors, and ultra-wealthy individuals on securities like stocks and bonds (as opposed to commodities like real estate and other tangible goods). The Act required annual registration of some private fund advisors with the SEC, and generally prohibited fraudulent transactions for the protection of investors.
The Act remained largely unchanged until the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act), passed in the wake of the 2007-2008 financial crisis. The Dodd-Frank Act amended the Advisors Act, increasing the SEC’s oversight of private fund advisors by requiring most advisors to register with the SEC and authorizing reporting and recordkeeping requirements to reduce risk to investors. The Dodd-Frank Act added a new section to the Advisors Act which allowed the SEC to promulgate any new rules it sees fit to restrict sales practices, conflicts of interest, and compensation schemes contrary to the public interest and in the protection of investors. It is here where the SEC finds authority for its new private fund rules.
But first, what are private funds?
Private funds are investments that pool capital from one or more “accredited investors” and then invest those funds in securities like stocks and bonds offered by private hedge funds, private equity funds, and venture capital funds not available to the public. Accredited investors can be institutions like banks and pension funds or ultra-wealthy individuals. Accredited investors have a certain net worth, hold a certain amount in investments, or have sufficient industry expertise, designations, or other credentials to evaluate and invest in such private offerings.
The SEC has historically viewed accredited investors as sophisticated enough to navigate the world of private equity without the same level of oversight and protection as middle-class individual and family investors. Thus, the private funds sophisticated investors invest in have generally avoided extensive regulation under the Advisors Act and Dodd-Frank Act, including registering with the SEC. Until now.
Increasing importance of the private funds industry
Private fund assets under management by advisors have increased from $9.8 trillion in 2012 to nearly $27 trillion in 2022. The number of private funds has increased from 31,717 to 100,947 over the same period. Indeed, private funds owned by endowments, pensions, and the ultra-wealthy now hold more assets than commercial banks.
Private funds and their advisors, then, play an increasingly prominent role in the lives of millions of Americans planning for retirement. Individuals (including public service workers like law enforcement officers and public school teachers) participating in public and private pensions and other retirement plans, endowments, and foundations have indirect exposure to the private funds those very entities invest in. The regulation and oversight of private funds are increasingly prescient issues to retired or soon-to-be retired Americans. Federal financial regulations in the past have been shown to reduce misreporting of results to investors, and the passing of the Dodd-Frank Act increased capital to hedge funds. Similar results to the new rules, in turn, could also improve efficiency and capital formation in addition to providing security to investors, including the public service workers that have such an impact on our communities.
Part Two (upcoming): New Rules, Industry Response, and Implications