A lawsuit was filed last month by a coalition of major private equity firms and hedge funds, including the Managed Funds Association, American Investment Council, National Venture Capital Association, and National Association of Private Fund Managers. The lawsuit aims to block new regulations recently passed by the Securities and Exchange Commission (SEC) that would require greater transparency and improved investor terms from asset managers.
Last year, several hedge funds including Millennium Management and HBK Capital Management established the National Association of Private Fund Managers in Texas, as reported by The Wall Street Journal. Their Texas business registration allowed the group to file its lawsuit against the SEC in the Fifth Circuit Court of Appeals, which has a majority of Republican-appointed judges (19 to 6 Democrat-appointed). The New Orleans-based Fifth Circuit has become a go-to court for conservatives and corporations seeking to overturn regulations, on issues ranging from abortion pill access to SEC authority.
Eugene Scalia, a partner at Gibson, Dunn & Crutcher LLP, and the lead attorney representing the plaintiffs, argued in the lawsuit that the SEC exceeded its legal powers by adopting the regulations without proper notice-and-comment procedures. He also contends the rules are arbitrary, capricious, an abuse of discretion, and unlawful. Private funds like hedge funds, private equity, and venture capital have historically faced limited oversight, under the rationale that their wealthy, sophisticated investors can negotiate terms directly with managers. Critics argue that this enables managers to charge opaque fees, overvalue assets, and engage in conflicts of interest. For example, they claim that managers sometimes offer select investors better information, lower costs, or preferential redemption rights when launching new funds, then use their participation to attract others with worse terms.
SEC Rule Change
The disputed regulations were approved by the SEC in August through a 3-2 vote that was split along party lines. They impose new requirements on private funds, which oversee nearly $27 trillion in assets for institutional investors like pensions and endowments as well as high net worth individuals. Under the new rules, private fund managers must furnish investors with quarterly financial statements outlining the fund's performance and fees. The regulations also mandate that the funds undergo annual audits and impose restrictions on certain practices, such as side letter agreements that provide more favorable terms to chosen investors over others. The coalition argues that the SEC overstepped its legal authority in implementing these
rules while an SEC spokesperson said the agency “undertakes rulemaking consistent with its authorities and laws governing the administrative process, and we will vigorously defend the challenged rule in court.” SEC Chair, Gary Gensler, has expressed confidence in the SEC's power to enact the regulations.
As the AUMs of private funds balloon, regulators worry that their present size exceeds that of commercial banks. According to data from the SEC, private funds saw their total assets under management increase dramatically, rising 171% between 2012 and 2022. This growth occurred as pension funds and other institutional investors poured money into these investment vehicles, hoping they could outperform the broader stock market. The SEC says its new regulations aim to protect smaller investors by requiring quarterly statements, annual audits, and restricting
certain preferential deals.
According to Tyler Gellasch, president of the investor advocacy group Healthy Markets Association, an unfavorable ruling could limit the SEC's oversight beyond just private funds. He pointed out the SEC relied on the same anti-fraud statute to craft this rule as it does to regulate other asset managers. Therefore, the court's decision in this case could have far-reaching implications in determining the scope of the SEC's power to regulate the broader investment industry. “If the courts determine that the SEC doesn’t have authority to require disclosures, audits, and basic fairness terms to private funds, then the agency doesn’t have authority to fulfill its mission,” Gellasch said.
Does More Regulation Really Protect Investors?
Some argue additional regulation of private funds like hedge funds and private equity is not needed, since these vehicles already primarily serve highly sophisticated institutional investors and ultra-high net worth individuals capable of protecting their own interests. Pension funds, endowments, foundations, insurance companies, and family offices willingly allocate capital to alternative assets, drawn by the potential for diversification and above-market returns.
With ample resources and expertise, these institutional investors conduct thorough due diligence, analyzing track records, strategies, risk management practices, fees, and fund governance. They negotiate terms directly with fund managers to secure the most advantageous deals before investing. Additional disclosure requirements seem superfluous given these investors are financially savvy and have significant leverage to obtain the information they demand from managers.
Furthermore, greater regulation may perversely harm the institutional investors they are meant to protect. More rules could reduce hedge funds' alpha generation capabilities, lower net returns, or drive up administrative costs for managers, which are passed on to investors. Institutions might be restricted from funds right-sized for their risk tolerance. Excessive red tape could also deter promising new fund launches. Rather than enhancing investor protections, additional regulations could make the playing field less attractive for major institutions allocating to alternatives.
Since pension funds, endowments, family offices and other qualified investors willingly invest in private funds, contenders of the regulation argue the market is working efficiently without further intervention. These highly capable parties can look out for their own interests when partnering with asset managers. More SEC rules could be an unnecessary overreach given the sophistication of the involved institutions.
Ultimately, the court's decision will deliver a significant verdict on the scope of the SEC's oversight capabilities. The judiciary is tasked with settling this struggle for regulatory supremacy.