In this article for Bloomberg Law, partner Bob Allen discussed how the Securities and Exchange Commission (SEC) will prioritize the regulation of private equity and hedge funds, or private funds.
Financial regulators’ work over the past several months has been dominated by a series of highly publicized cases against crypto exchanges and the executives who ran them. These cases align with what many see as regulators’ central function: protecting unsophisticated, retail investors in public markets.
However, the Securities and Exchange Commission and the Department of Justice have been less focused on retail investors in recent years. Both agencies are paying greater attention to participants in private markets like hedge funds and private equity.
When the SEC announced its 2022 examination priorities last March, regulation of private equity and hedge funds, or private funds, was listed at the very top. The SEC explained it intended to focus on those funds’ “compliance programs, fees and expenses, custody, fund audits, valuation, conflicts of interest, [and] disclosures of investment risks,” among other things.
These focuses are meant to protect investors in private funds—typically sophisticated investors like pension funds, institutions, and high-net-worth individuals. This is inconsistent with the SEC’s traditional focus on retail investors.
In fairness, protecting working families and retail investors was third on the SEC’s priorities list. It is clearly still a priority, and the SEC would presumably say that the way it orders its priorities in press releases does not mean one is more or less important than the other.
But for every year between 2015 and 2021, retail investors were listed first. The switch to private funds is a notable change.
The SEC is not the only regulator focused on private funds.
The US Attorney’s Office for the Southern District of New York, which has historically brought an outsized number of financial cases, expressly stated at a securities conference in March 2022 that it was focused on private equity and hedge funds.
Since then, prosecutors in the Southern District have brought criminal charges against individuals associated with Archegos Capital Management, Infinity Q Capital Management, and Allianz Global Investors US—all investment advisers that operated hedge funds marketed to institutional and high net worth investors.
Scrutiny Will Increase
In a different time, the DOJ might have thought those investors could fend for themselves, and that its resources should be allocated elsewhere. But these cases show the department is devoting significant resources to pursuing actions in private markets where retail investors are largely, if not entirely, absent.
What does this mean for future enforcement? Priorities can change, but all signs suggest that private funds will remain under the microscope.
The SEC and DOJ will continue to investigate whether private funds are properly valuing their assets and reporting those values to investors. The agencies will also look to see whether the funds are calculating, charging, and disclosing management fees fairly.
Finally, regulators will probe whether the funds are complying with their own environmental, social, and governance, conflict of interest, and insider trading policies, among other things.
The SEC and DOJ have successfully brought several cases in these areas, and have received outsized penalties from private funds. This will only encourage more cases in the future.
Financial regulators also tend to follow the money, and that money is increasingly being held in private funds.
Private funds had more than $20 trillion in gross assets under management in the first quarter of 2022, a $3 trillion increase from 2021. In the past five years, there has been a 70% increase in the assets managed by advisers to private funds, according to the SEC.
Steps to Take
This is not to say that publicly traded companies can exhale or lessen their attention to traditional enforcement areas like disclosures and accounting. The SEC and DOJ will both assuredly continue to bring a steady stream of cases against public companies and their executives.
But private equity and hedge funds should no longer take solace in the fact that they operate in sophisticated markets and service institutional investors.
In this environment, private funds should make sure they have top-notch controls and to invest in their compliance programs.
Companies cannot eliminate completely the risk of regulatory investigations and violations, no matter how committed they are to compliance and corporate integrity. The regulatory regime governing private funds is just too complicated, and, in many cases, too ambiguous, to avoid infractions.
But investments in compliance can help limit the number of infractions, which can easily justify the expense. And the past few years have shown regulators will punish companies that have underdeveloped compliance programs.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Bob Allen, a partner in Kirkland & Ellis’s litigation and government, regulatory and internal investigations practice groups, focuses on representing corporations and individuals in criminal and regulatory investigations, as well as complex litigation. Chloe Reum contributed to this article.