(Article from Registered Funds Alert, September 2020)
For more information, please visit the Registered Funds Alert Resource Center.
In June 2019, the SEC issued a concept release seeking comments “on possible ways to simplify, harmonize, and improve the exempt offering framework to promote capital formation and expand investment opportunities while maintaining appropriate investor protections.”
To date, the SEC has received over 170 comment letters from a wide range of industry participants, including a letter from a group of 15 securities law professors. The law professor letter questions whether expanding access to private markets will raise investor protection concerns and argues that existing proposals to increase retail investor participation through pooled investment vehicles suffer from misconceptions about the private markets.
We agree with the law professors that any expansion of retail access to private markets must be careful to preserve core investor protections; however, we believe pooled investment vehicles, specifically registered investment companies and BDCs, are the best way to increase investor access to private markets investment strategies, as significant investor protections are fundamental elements of the existing regulatory framework for these types of fund structures. This Alert responds to some of the “misconceptions” raised in the law professor letter regarding retail access to private markets through pooled investment vehicles. Some of the arguments raised in the law professor letter relate to business issues, including the relative performance of private markets investments. This Alert focuses on the legal issues raised in the letter but we note that there is a significant body of research offering rebuttals to the law professors’ business points.[1]
*****
Existing Retail Structures Are Not a Direct Substitute; Only Offer Limited Exposure to Private Markets
The law professor letter notes that retail investors can already access private markets indirectly through mutual funds and BDCs. Unfortunately, these existing channels are not true substitutes for direct access to private markets or only offer limited exposure to private markets.
According to a 2018 report from Morningstar, a low percentage of mutual funds have any exposure to private company equity. Even among large-cap equity funds, the subset of the mutual fund industry that has embraced private-company investment the most, only 5.8% of the 1,204 large-cap equity funds in Morningstar’s database as of December 2017 had any level of investment in private companies. And even among mutual funds that hold equity in private companies, total exposure is typically modest and the resulting impact for fund investors is likely to be minimal. The median mutual fund in the Morningstar report invested in three privately held companies, totaling just 0.71% of overall fund assets.
These small position sizes should not come as a surprise–a registered open-end fund is prohibited under Rule 22e-4 of the 1940 Act from investing more than 15% of its net assets in illiquid securities, thereby limiting the extent to which it may invest in private companies and private funds. In response to the Concept Release, a number of commenters, including the Institutional Limited Partners Association, recommended that the SEC ease liquidity constraints for target date funds with longer investment horizons, to provide greater flexibility to invest in illiquid assets, including private companies.
In contrast to equity mutual funds, closed-end investment company structures are better suited to pursue illiquid investment strategies as they do not provide daily redemption rights for investors and therefore are not subject to Rule 22e-4. However, few private equity-style closed-end regulated funds exist. While BDCs originally were intended to be venture capital vehicles, Sections 17 and 57 and related rules under the 1940 Act make it difficult for a BDC or other closed-end fund to pursue a private equity strategy by taking significant equity stakes in portfolio companies, particularly for those sponsors who might manage retail vehicles alongside institutional ones. For example, if a registered fund or BDC buys more than 5% of the equity of a company together with a private fund, following the initial investment, the 1940 Act would prohibit any follow-on transaction with the portfolio company (such as contributing additional capital in a subsequent financing round) on the basis that the portfolio company is an affiliated person of the registered fund or BDC. The 1940 Act regulatory restrictions also significantly constrain regulated funds from co-investing alongside private equity funds that take controlling equity stakes in companies. As a result, most closed-end funds and BDCs pursue an income-oriented strategy and focus on investments in the debt of small and mid-sized companies and are unlikely to provide exposure to private equity investments.
For all of these reasons, the claim that retail investors already have access to private markets strategies is a gross mischaracterization of the present investment landscape.
Private Markets Regulated Funds Provide Access to Experienced Managers, Liquidity and a Diverse Portfolio
The law professor letter also argues that current proposals for pooled vehicles structures include features that cannot coexist in practice, including investor liquidity, illiquid investment exposure, broad diversification, and the lack of a need for retail investors to monitor the fund manager and the fund’s investments. Below we discuss why these attributes actually can exist in a properly structured regulated fund (if the SEC provides appropriate relief from certain regulatory restrictions, including those discussed above).
Various Liquidity Options Are Available for Regulated Funds With Illiquid Strategies
Regulated fund pursuing a private markets strategy can offer investors several different types of liquidity options. A regulated fund pursuing a private markets strategy would likely be structured as a closed-end fund due to the illiquid nature of its investments. Closed-end funds are not required to provide shareholders with daily redemption opportunities like open-end mutual funds, allowing a closed-end fund to manage liquidity with more predictability. Closed-end funds can list their shares on a national securities exchange, providing liquidity to investors using the most elegant liquidity system for investments ever devised—the U.S. stock markets. For unlisted closed-end funds, it is quite common to provide shareholders with limited periodic (often quarterly) liquidity through an interval fund or tender offer fund structure (for example, a fund might repurchase up to 5% of its shares each quarter). An unlisted private markets regulated fund would likely allocate a modest portion of its portfolio to a more liquid strategy to facilitate the fund’s periodic liquidity, or could choose to do less frequent repurchases for a larger portion of the fund’s shares to align with the liquidity events of its underlying portfolio companies.
Diversification Is Achievable Through Fund-of-Funds Structures and Required for Pass-Through Tax Treatment
We agree with the law professor letter that holding an interest in a single private equity fund may not provide the average retail investor with meaningful diversification, and that a regulated fund of private funds structure is one alternative that addresses these diversification concerns. It is worth noting that a current SEC staff position would preclude most retail investors from investing in any such regulated fund of private funds. As a result of the liquidity rule discussed above, any regulated fund of private funds would need to be structured as a closed-end fund. However, that SEC staff has historically required that offerings of registered closed-end funds that invest more than 15% of their assets in private funds be limited to accredited investors only. A number of industry commenters, including the Committee of the Business Law Section of the American Bar Association, encouraged the SEC staff to change its informal policy imposing the 15% limitation, and the Director of the Division of Investment Management recently suggested that the Staff was reconsidering that limitation. The law professor letter also fails to acknowledge that regulated funds are required to provide significant diversification to qualify for pass-through tax treatment.
We disagree with the law professor letter that a regulated fund of private funds could not be structured to ensure retail investors have access only to experienced asset managers and address layering of fees. As one industry participant commented, the Commission could consider limiting retail access to managers with a significant institutional investor base to ensure that investors are exposed to experienced managers only. As a result, retail investors in a regulated fund of private funds would have the ability to invest alongside institutional investors in the underlying private funds, allowing retail investors to achieve incentive alignment with institutional investors, and to benefit from the negotiation of terms of the private funds by sophisticated investors.
And as discussed in our comment letter on the concept release, if the SEC were to allow for the creation of regulated funds of affiliated private funds, where the regulated fund invests in a multiple private funds affiliated with the regulated fund’s investment adviser, the SEC could also impose certain restrictions to address duplicative fees, including a requirement that the regulated fund’s board of directors only approve fund-level fees for services that are in addition to and not duplicative of services at the underlying affiliated private fund level. This structure is common in the mutual fund of funds context. In addition to reduced fees, a regulated fund of affiliated private funds may also offer investors certain benefits unavailable to a fund that invests in unaffiliated private funds, including better alignment of interests between management of the regulated fund and underlying private funds and access to the best possible terms in respect of each investment (if the SEC conditioned any such relief on most-favored nation status on key terms).
Public Reporting and Independent Oversight Are Inherent Features of Regulated Funds
The legal framework of a regulated fund guarantees certain core investor protections and is designed to provide investors investment management services by a registered investment adviser who owes a fiduciary duty to its funds (including, notably, a fiduciary duty not to charge excessive compensation), subject to the oversight of an independent board of directors and, ultimately, the SEC. Regulated funds also are public reporting companies that publish quarterly reports that include a schedule of every investment held by the fund, along with the value attributed to each investment. Publicly traded regulated funds are further covered by the analyst community, who scrutinize these vehicles similar to the manner in which they analyze public operating companies.
Regulatory Restrictions Should Be Lifted to Enable Optimal Regulated Fund Structures
The law professor letter fails to appreciate that there are regulatory restrictions that currently prevent regulated funds that focus on private markets investments from being structured in the optimal way for retail investors. If the applicable regulatory restrictions were lifted, a regulated closed-end fund could offer all of the features that the law professor letter claims “cannot coexist in practice.” Liquidity could be offered through a stock exchange listing or periodic repurchase offers. Diversification could be offered through fund of funds structures, and would be necessary to meet relevant requirements for pass-through tax treatment. The investing public would have significant transparency into the portfolio and performance of a fund managed by a registered investment adviser with oversight from independent directors. The SEC could also condition certain aspects of necessary relief to ensure that retail investors benefit from the negotiation of terms by institutional investors. It is difficult to imagine a better structure for retail investors to access private markets than through a regulated fund.
[1] See e.g., Robert S. Harris, Tim Jenkinson & Steven N. Kaplan, How Do Private Equity Investments Perform Compared to Public Equity?, 14 J. INV. MGMT. 14, 15 (2016) (finding that returns to investors in private equity funds with post-2005 vintage years have been roughly equal to returns in the public markets but acknowledging “[t]hat performance will improve if the historical J-curve pattern of private equity funds—in which fund multiples increase over a fund’s life—continues to hold.”); Committee on Capital Markets Regulation, Expanding Opportunity for Investors and Retirees: Private Equity at 19 (November 2018) (noting that adding a private equity component to an investment portfolio can provide protection in times of market stress); Georgetown Center for Retirement Initiatives, The Evolution of Target Date Funds: Using Alternatives to Improve Retirement Plan Outcomes (June 2018), (finding that allocating just 20% of a target date fund’s portfolio to private equity funds increased median annual retirement income by 13%, as compared to a baseline portfolio without private equity investments).