At the end of August, the SEC, in a 3-2 vote, adopted a package of highly anticipated private funds rule reforms. Of particular relevance to institutional co-investors is a provision that would prohibit advisers from allocating fees and expenses related to a portfolio investment, including those related to broken deals, on a non-pro rata basis among advisory clients, unless certain disclosure and fairness requirements are satisfied.
As is well known to investors active in this space, sponsors and co-investors have historically taken a wide range of approaches to allocating broken deal risk, with the typical passive financial co-investor position being that they should not bear any such risk since they have no control over the underlying transaction.
The more prescriptive approach under the SEC’s new rules potentially represents a material change from current norms. Below we briefly discuss:
- The specific new rule that would constrain certain non-pro rata allocations of broken deal fees;
- Sources of uncertainty regarding the rule’s ultimate effects; and
- Potential near-term implications for co-investment negotiations.
The private funds rules: Restricted activities and broken deal expenses
The new private funds rules designate a category of “restricted activities,” which are generally permissible under the new regime but are subject to disclosure, consent and/or similar requirements. The imposition of non-pro rata fees is one of the designated “restricted activities” and is specifically addressed in new Advisers Act Rule 2011(h)(2)-1.
In summary, this rule would prohibit any private fund adviser from charging or allocating fees or expenses related to a portfolio investment on a non-pro rata basis when multiple private funds and other clients of the adviser are participating, unless two conditions are satisfied:
- Any non-pro rata fee or expense must be “fair and equitable” under the circumstances; and
- The adviser must disclose the non-pro rata fee or expense to affected investors prior to imposing it, along with an explanation as to why the allocation is fair and equitable under the circumstances.
Commentators, in particular those representing a large sponsor base, have thus far generally interpreted this rule to apply to the allocation of broken deal expenses to co-investors alongside private equity funds, although, as discussed below, there is uncertainty around this interpretation.
For its part, the SEC appears to have presupposed that the new rule will apply in this manner. The SEC’s adopting release for the private funds rules includes a paragraph opining that co-investors will continue to provide capital for investment opportunities notwithstanding the new requirements (and thus implying that co-investors would be subject to the new requirements). We also note that non-pro rata fee allocations, both in general and with respect to broken deal costs in particular, have been a focus of the SEC in recent years and have been the basis for enforcement actions.
On its face, the rule would of course continue to allow non-pro rata allocations of broken deal fees provided the rule’s fairness standard and disclosure requirement are satisfied. We note, however, that the “fair and equitable” standard included in the rule is vague and that the adopting release includes relatively little in the way of useful clarification.
The SEC acknowledges that expenses that are specifically associated with a particular investor may fairly be allocated to that investor and not others. As most industry participants know, however, broken deal fees would typically not be associated with a specific investor in this manner. Sponsors and co-investors instead typically allocate broken deal risk based on negotiating dynamics and broader commercial considerations. The extent to which the SEC would consider this approach “fair and equitable” within the meaning of the rule is unclear.
Uncertainties regarding application
While the SEC’s adopting release presumes the applicability of Rule 2011(h)(2)-1 to co-investment vehicles, there may be interpretive questions as to its applicability to single asset co-investment vehicles specifically. On its face, the rule only applies to fact patterns where “multiple private funds and other clients” advised by an adviser have invested in a given investment. (Emphasis added.)
Based on this language, co-investment vehicles should only be within the scope of the rule to the extent they are “clients” of a given adviser. In the preponderance of co-investment transactions, advisers have taken the position that single-asset co-investment vehicles are not clients for Advisers Act purposes, on the basis that the advisers’ management of such vehicles is ministerial in nature and does not involve provision of separate investment advice to the co-investors or co-investment vehicles.
This position also means that advisers typically do not subject co-investment vehicles to existing Advisers Act rules, including those that would require separate audits or surprise custody exams, and do not view themselves as owing fiduciary duties to such entities. The SEC has historically stated that determinations as to “client” status are dependent on the relevant facts and circumstances, and the SEC has been reluctant in recent years to provide formal guidance regarding whether various co-invest arrangements are client relationships. The private funds rule adopting release does not include any new clarification on this point. Advisers therefore may still have a basis to conclude that single asset co-investment funds are not “clients” that would be within the scope of Rule 2011(h)(2)-1, though we expect that such determinations may face higher regulatory scrutiny going forward given their importance under the new regulations.
Another source of uncertainty as to the applicability of Rule 2011(h)(2)-1 to co-investors is the legality of the new private funds rules more broadly. Commissioner Hester Pierce, one of the two SEC commissioners who voted against the new rules, issued a statement in connection with the vote pointedly criticizing the rules in a number of respects.
She argued, among other things, that the new rules were promulgated under a section of the Advisers Act that is aimed at regulation of advisory relationships with retail investors, rather than the institutional investors that comprise almost all private fund investors.
Earlier in September, several established asset management trade groups sued the SEC in the Fifth Circuit Court of Appeals challenging the legality of the new rules, in a case that we anticipate will echo many of the arguments set forth by Commissioner Pierce in her statement. It is possible that this case will ultimately result in some or all of the new rules being overturned, potentially including the restricted activities rule, although it is difficult at this time to handicap the likelihood of success or the likely timing of any final decision in the case.
Near-term negotiation implications
For larger private fund investors, Rule 2011(h)(2)-1 will not become effective until 12 months from publication of the new rules in the federal register, which has not yet occurred. Even during the period before the rule takes effect, however, we believe that sponsors may seek to use the rule as leverage to impose broken deal expenses on co-investors more broadly than has been the case in recent practice.
Against this backdrop, we would encourage co-investors to:
- Continue their historical approach to broken deal risk sharing for deals closing prior to the efficacy of the rule;
- Remain mindful that legitimate questions exist as to the ultimate interpretation and application (and even validity) of the rule;
- Consider requesting additional oversight over underlying transaction closing conditions to better manage risk internally;
- If necessary, consider delaying commitments until late in the deal process (or until closing) so as to minimize broken deal risk;
- Where appropriate, negotiate to limit the circumstances where a co-investor would bear broken deal fees (e.g., where a breach by the co-investor is the sole cause of such fees or expenses); and
- Where appropriate, seek to share in any termination fees received by sponsors to at least partially offset the risk of broken deal fees that would be borne by co-investors.
The new private funds rules may ultimately change the way parties allocate broken deal risk, but at this time we see no reason for co-investors to make concessions in this area that aren’t otherwise commercially warranted.
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