Where the fault lies

From his first days, SEC chairman Gary Gensler promised to change the way private funds went about their business. After nearly a century of letting private equity, venture capital and hedge funds dwell in the shadows, he argued, it was time to yank them into the daylight.

Last week, the chairman formally began his project. The Commission voted to put out for public comment the first and most sweeping disclosure rules for registered private fund advisers since Dodd-Frank hit the books. His staff followed it with a risk alert from the Division of Exams that blasted the entire industry for failures, from improper disclosures to lousy due diligence to hedge clauses.

That may be the least of it. Still ahead: new rules for exempt funds – all 174,000 of them, new (narrower) definitions for accredited investors, “enhanced disclosures” for SPACs and family offices, and (judging by the risk alert) a raft of enforcement cases. Meanwhile, the Biden administration is moving quickly to impose Bank Secrecy Act rules on real estate and foreign private funds, Congress’s first-ever bipartisan anti-kleptocracy caucus is taking a hard look at the industry, and federal prosecutors are promising to go dagger-to-hilt on corporate misconduct.

This is already a seismic year for industry.

Early rumblings

Gensler gets (and deserves) most of the attention for being the prime mover here. But if you listened carefully enough, you could’ve heard rumblings long ago.

The first and greatest shock, of course, was The Great Recession. It showed Congress and the public that private funds weren’t just some sleepy patch of land where the ultra-rich or big pension funds frolicked. It showed that the industry had tectonic heft of its own that – if not watched carefully – could flatten the whole world.

Dodd-Frank was only one effort to earthquake-proof the economy from private funds. Among other things, it required private funds with at least $1.5 billion in AUM to register with the SEC and follow the disclosure rules under the Investment Advisers Act. Things might have rested there – some (light) disclosure for some of the largest funds just to make sure regulators could keep quakes from cascading – except that two years after Dodd-Frank, president Obama signed The JOBS Act.

Too big to fail

The JOBS Act was written to help make it easier for entrepreneurs or rising companies to raise cash quickly without the regulatory drag of the Advisers Act. Among other things, it repealed decades-old rules that had kept firms from making “general solicitations” (basically, selling their stuff to the big public) as long as firms pinkie swore they’d only sell to accredited investors – basically, rich people, families or institutions.

By its own lights, The JOBS Act was a success. Between 2009 and 2019, more than 173,000 private equity, hedge fund and venture capital firms hung out their shingles. They raised nearly $13.6 trillion from 5.9 million investors, SEC statistics show. Today, for every dollar that goes into a traditional IPO, three go to private funds.

The JOBS Act’s success helped push the plates that now grind beneath industry’s feet. Think whatever you like of Gensler’s reform brief. The thing to notice is that his argument for private fund disclosures rests in part on the idea that, in essence, the industry is too big to fail.

“These funds hold about $17 trillion in gross assets under management,” he said in a speech to Washington’s Exchequer Club just four days before the Form PF rulemaking notice was approved. “If we can use our authorities to bring greater transparency and competition into that market, that helps portfolio companies on the one hand, and the pensions and endowments that are investing in that space on the other.”

‘Fend for themselves’

Part of the reason private funds had been exempt from public disclosures rules is because policymakers assumed that rich people either knew what they were doing or could afford to be stupid with their own money. As the Supreme Court said in the seminal 1953 SEC v. Ralston Purina case, the wealthy “are able to fend for themselves.”

For Gensler and those who support him, the problem is that policymakers didn’t consider that an idea like personal wealth might be subject to evolution. Washington’s first definition of “accredited investor” came in the earliest days of the Reagan administration, when regulators laid down the first wealth thresholds for those who could and couldn’t fend for themselves. That was also Washington’s last definition of accredited investors – until last year, when the SEC under Republican chairman Jay Clayton expanded the population of accredited investors to include some financial services pros.

This (benign or malign) neglect meant that, thanks to ordinary inflation, increasing numbers of otherwise ordinary people found themselves “accredited” – but (in Gensler’s view) without any of the sophistication implied by that accreditation.

‘Small Earthquake in Chile’

Today, experts estimate that anywhere from 8.5 to 10.6 percent of American households meet the definition of accredited investors. Most accredited investors tend to be older – the median age of an accredited investor is between 60 and 64, by one estimate. That is to say: They’re the very population of folks that the public disclosure laws were designed to protect in the first place.

This is the irony that gives Gensler and his allies their writ, and their sense of urgency. Had private funds been slightly less successful at what they do – had they been slightly less democratic about the way they do it – they might to this day be untroubled by Washington.

The great Anglo-Irish critic Claud Cockburn once entered and won a dull headline contest among his friends at The Times of London. “Small Earthquake in Chile,” he wrote. “Not many dead.” There can be no question that the earth is shaking beneath industry’s feet. The scale of the quake and its casualties will have to be measured another day. For now, it’s probably a good idea for fund advisers to pick up the phone to their compliance departments and start proofing their buildings.