Leading Institutional Investors Urge SEC to Take Action in Private Equity Market

On February 12, 2019, the Institutional Limited Partners Association (ILPA) submitted a letter to the Securities and Exchange Commission (SEC) asking the SEC to take certain steps to ensure that investment advisers in the private equity market are subject to fiduciary duty requirements.¹ The SEC has recently focused on devising a comprehensive interpretation of the fiduciary duties that investment advisers owe to their clients. ILPA has been vocal on this topic and has submitted two prior letters in addition to this most recent one and attended various meetings with the Chairman, Commissioners and staff of the SEC.  For parties on both sides of the issues, ILPA's advocacy and the SEC's response bear watching.

ILPA describes itself as the "voice of institutional investors in the private equity asset class, known as Limited Partners." According to ILPA, it "has approximately 500 member institutions, which represent over $2 trillion in private equity assets under management, including U.S. and global public and private pension funds, insurance companies, university endowments, charitable foundations, family offices, and sovereign wealth funds."

ILPA submitted a letter to the SEC on August 6, 2018, after the SEC announced a Proposed Interpretation Regarding Standard of Conduct for Investment Advisers (the Proposed Interpretation) and requested comments.² In that letter, ILPA stated its strong interest in a requirement that investment advisers to private equity funds be registered and subject to regulations under the Investment Advisers Act of 1940 (Advisers Act), including fiduciary duty requirements. On November 21, 2018, ILPA submitted a follow-up letter in which it urged the SEC to rescind the Heitman Capital No-Action Letter, issued in 2007, given market developments since then.³ The Heitman Capital No-Action Letter allowed for the elimination of contractual fiduciary protections by permitting the inclusion of hedge clauses into limited partnership agreements, which typically require funds to indemnify advisers for liability of any nature unless the adviser's actions were grossly negligent, reckless, willfully improper, or fraudulent.

Most recently, in ILPA's February 12, 2019 follow-up letter, it again urged the SEC to rescind the Heitman Capital No-Action Letter and—going beyond comment on the Proposed Interpretation—also encouraged the SEC to (i) issue a statement indicating that any settlements of enforcement actions with a private fund adviser be conditioned upon that adviser assuming those costs rather than seeking indemnification from their investors, and (ii) conduct an examination sweep of hedge clauses. In addition, ILPA recommends that the SEC make the following clarifications in the Proposed Interpretation:

• Require private fund advisers to explicitly and clearly disclose the standard of care under both state law and the Advisers Act owed to LPs and the fund.
• Clearly state that the standard of care owed to the clients of private fund advisers under the Advisers Act is a "negligence" standard.
• Limit "pre-clearance" of conflicts of interest, and require that specific details of each conflict be presented to the LPs to receive true "informed consent."
• Indicate that having a Limited Partner Advisory Committee (LPAC) is best practice for private fund advisers, and all perceived conflicts should be presented to the committee for resolution.
• Provide more clarity surrounding hedge clauses, including the limits of their scope, and the facts and circumstances in which they can be used.

Given the broad use and market acceptance of hedge clauses and conflicts provisions in the limited partnership agreements of private equity funds (as well as venture capital, real estate, hedge and other private investment funds), the adoption of ILPA's proposed rescission of the Heitman Capital No-Action Letter and limitations on "pre-clearance" of conflicts of interest would likely be a "sea change" for the industry.  Whether or how the SEC will respond to ILPA's concerns remains to be seen and merits monitoring. Some SEC officials have indicated that with the agency's shift towards protecting retail investors, examination and enforcement activity directed at private equity may be on the decline,⁴ which may explain ILPA's concerns. With respect to ILPA's call for a statement that managers bear the cost of SEC enforcement actions, the Division of Enforcement does not generally issue policy statements and will be hesitant to engage in "rulemaking by enforcement." That said, close monitoring of what senior enforcement officials say in speeches, testimony and agency press releases could yield clues as to whether any of ILPA's concerns may become enforcement priorities. Routine enforcement activity directed at private equity managers is likely to continue, as reflected in two cases filed by the Division of Enforcement in December 2018.⁵

From an examination perspective, it is foreseeable that SEC examination requests in the near term may include an increased focus on hedge clauses. While the SEC's Office of Compliance, Inspections and Examinations may explore the issue in individual examinations, it is unlikely that the exam program will initiate a nationwide sweep unless it has reason to believe there are widespread federal securities law violations occurring. Nevertheless, given ILPA's ongoing calls for greater regulatory oversight of private equity managers, it is likely senior examination officials will be sensitive to the issues raised by ILPA, which could translate into targeted examination activity.