Private Markets: Who’s Watching Out for Individual Investors?

In debates over the need for additional regulatory protections for private market investors, a common argument is that these investors are predominantly large, sophisticated institutions capable of protecting themselves. However, the landscape has evolved significantly. Today, individual investors contribute a substantial portion of the capital raised by private asset managers, and their share of market is expected to continue to grow. This trend is often referred to as the “democratization of private markets.”

A recent illustration of this debate unfolded between the U.S. Securities and Exchange Commission (SEC) and a coalition of private fund manager associations (hereafter referred to as “Private Fund Managers”). In 2023, the SEC implemented new rules (“Rules”) to enhance the regulation of private fund advisors. The Private Fund Managers contested these Rules, asserting that the SEC exceeded its authority, given that existing laws presumed private fund investors could fend for themselves. In June 2024, the U.S. Court of Appeals for the Fifth Circuit vacated the Rules entirely.

Whether or not one agrees with the Court’s decision, some of the assumptions behind the differential treatment of investments intended for retail investors and those for institutional ones may no longer be true. In particular, the landscape of investors in private funds has changed dramatically since 1940 when the Investment Company and Investment Advisers Acts were enacted. With that in mind and with emphasis on the growing presence of individual investors in private funds, we look at the Rules from the perspective of what it may have meant for individual investors. In their absence, and mindful that there may be differences in interests among investors, we offer some strategies for individual investors to consider to better understand their investments and safeguard their interests in private funds.

SEC Private Fund Adviser Rules

In promulgating the Rules, the SEC sought to enhance the regulation of private fund advisers, providing better protection for investors and preventing fraud, deception, or manipulation by advisers. Some of the Rules applied to fund advisers registered with the SEC and others applied to all private fund advisers, which were defined expansively and consistent with existing regulation. When the SEC announced the new Rules, it said that it did so “on behalf of all investors – big or small, institutional or retail, sophisticated or not.”

The Rules introduced several key requirements for private fund advisers:

1. Quarterly Statements: Advisers were to provide detailed information in their quarterly statements, including information about fees, expenses, and compensation.
2. Annual Audits: Each managed fund required an annual audit.
3. Fairness Opinions: Advisers proposing “GP-led secondary transactions” mandated a fairness opinion.
4. Restrictions on Passing Through Certain Costs and Non-Pro Rata Costs: Private fund advisers were restricted from charging certain fees or expenses without disclosure or investor consent.
5. Preferential Treatment Disclosures: Advisers were to disclose any preferential rights granted to investors.

Each of the SEC’s Rules, except the fifth, broadly touches all fund investors, regardless of their size and sophistication. Arguably, further regulatory oversight is not needed for the first four Rules because large, sophisticated investors in a private fund can negotiate those protections on behalf of all investors and their interests are aligned. This assumes that all funds have large, sophisticated institutions as investors negotiating rights with the fund manager. While this may have been historically true for private funds, it is now not always the case, perhaps bolstering the SEC’s motives for imposing the Rules.

The fifth element, the preferential treatment rule, however, seeks to protect some private fund investors from special arrangements negotiated by others through side letters or arrangements outside of the primary fund documents which apply to all investors. Among other things, this rule prohibits managers from giving some investors special redemption rights and/or information rights if those special rights could materially and negatively affect other investors.

Typically, large institutional investors negotiate these preferential rights due to their substantial fund commitments, co-investment relationships, and other factors. The SEC’s intent to protect “all investors,” including individual investors, is most evident in this rule. Although investors have practical reasons to seek preferential rights, such as their substantial financial commitments and their own legal, regulatory, or reporting obligations, having these rights can give those investors an advantage over other fund investors. This means that investors who do not have these rights should be aware of the practical implications of these differential rights.

Fifth Circuit’s Decision to Strike the Rules and Their Characterization of Private Fund Investors

The Fifth Circuit’s decision to vacate the Rules relies upon the historical distinction between the protections afforded in the securities laws to retail investors in public funds versus the self-protection model found in private funds. In its opinion, the court adopted the reasoning of the Private Fund Managers:

…[T]he crux of the Private Fund Managers’ argument is that Congress drew a “sharp line” between private funds and funds that serve retail customers. The [Investment Company Act of 1940] further details requirements governing almost every aspect of a fund’s operations, and private funds are exempt from this regime. This is because “[i]nvestment vehicles that remain private and available only to highly sophisticated investors have historically been understood not to present the same dangers to the public markets.” Goldstein, 451 F.3d at 875.

The clear line of demarcation between public and private fund investors that the court embraces has been blurring, with smaller investors representing a prime target for sponsors offering private funds and a growing proportion of investors in some funds. These smaller investors meet the financial requirements under securities laws exemptions to invest in private funds, but they may not have the sophistication or, in many cases, the resources that institutional investors have to pursue their unique interests in those funds.

Growing Importance of Individual Investors in Private Funds

According to Bain & Company (“Bain”), private wealth investors (the term used to describe non-institutional but still substantial investors) globally have about $4 trillion invested in alternative assets (private equity funds, real estate funds, hedge funds, etc.), or approximately 15% of the total $26 trillion of assets under management by private fund managers in 2022. Importantly, the $4 trillion that individuals have invested in alternative assets represents only about 5% of their total assets, according to Capgemini. Looking ahead, Bain projects that individual investments in alternative assets will more than triple to $13 trillion over the next decade, comprising over 21% of total assets under management by private fund managers.

Individual investors, collectively, have increased their demand for private funds as they search for the prospect of higher returns and greater diversification. At the same time, as traditional sources of capital for private funds, such as defined benefit plans, have experienced more moderate growth, private fund managers and investment advisers seeking new sources of equity capital have focused considerable efforts cultivating individual investors and platforms for them to invest. Technological advancements and regulatory changes have facilitated this trend.

Qualifying as an accredited investor is an important linchpin in satisfying exemption requirements under the US securities laws. The SEC’s expansion of the definition of an “accredited investor” has allowed more individuals to invest in private assets. The development of technology platforms has also allowed wealth advisors and fund managers to handle investments by many investors, overcoming past challenges related to intensive onboarding and operational requirements of private funds.

Navigating the Complexities of Private Markets for Non-Institutional Investors

While the SEC’s Rules aimed to provide some protection for private fund investors, they did not fully address the complexities and lack of transparency inherent in private funds. The SEC’s authority to regulate private funds will likely remain limited for the foreseeable future, while the industry will continue to expand and attract capital from a greater number of individual investors. Individual investors and their advisors are wise to improve their knowledge of the workings of the private markets. This means becoming conversant in some of the critical areas in which individual investors are or can be disadvantaged compared to large, sophisticated institutions and where the interests of institutional and individual investors may diverge.

Although the democratization of private markets offers significant benefits to both investors and the industry, it also comes with associated costs and responsibilities. In this context, we explore two key themes in the Rules that have implications for individual investors:

1. Preferential Relationships

Large institutions, including fund managers, limited partners, and private wealth advisors, predominantly control the private markets. Individual investors entering this ecosystem can benefit from the access and leverage provided by private wealth managers and large institutional investors. However, their interests do not always align with these larger entities, necessitating prudence. Understanding each specific fund’s ecosystem is crucial to assess potential conflicts and their mitigation.

• Prospective investors should determine whether a fund is primarily geared toward institutional investors or whether it is primarily targeted toward retail investors.
• If a fund primarily serves institutional investors but also accepts subscriptions from individuals, it is reasonable to expect that some large, sophisticated institutions have negotiated a generally favorable agreement that will benefit all investors. However, there may be side letters or other arrangements that give certain large institutional investors rights and benefits that other investors do not have.

In their 2023 paper, Elisabeth de Fontenay and Yaron Nili place typical private fund side letter provisions into six categories: governance, disclosure, regulatory/tax, fee discounts, co-investment, and other financial terms. The most relevant ones for individual investors are fee discounts and the ability to be excused from investments or withdraw from the fund (both of which are categorized as “other financial terms”).

Fee Discounts

De Fontenay and Nili did not find significant prevalence of fee discounts in side letters. However, fee discounts to significant investors or anchor investors are common. They can appear directly in limited partnership agreements themselves, or indirectly through co-investment rights which often come with lower or no fees and may be granted or acknowledged in side letters. This effectively reduces the stated fees of a fund for the applicable investor.

• In performing due diligence, investors should ask the fund manager whether the Net Internal Rate of Return (IRR) disclosed for prior funds is based on fees paid by all investors, inclusive of any discounts granted, or if it represents the Net IRR for investors paying the highest fees. The latter Net IRR will give individual investors the truer sense of what they might expect to earn in a fund compared to how the fund manager has marketed the fund.

Excusal/Withdrawal Rights

Approximately 15% of side letters studied by de Fontenay and Nili include provisions allowing investors to be excused from certain investments or withdraw their interests. This excusal right may sound nefarious or like cherry-picking a portfolio but often is related to freeing investors from investing in banks or bank holding companies, and media companies because those investments can create significant regulatory issues for some institutional investors. Additionally, some excusal provisions apply to alcohol, gaming, firearms, and more recently coal to allow some investors to adhere to their own internal policies. The net effect of investors being excused from selected investments is that all remaining investors will own a greater percentage of those investments.

• In evaluating a private fund, investors should ask about excusal rights and the conditions and probability of them being exercised. This will allow investors to determine the risk of having a greater concentration in some portfolio companies and whether that risk is acceptable.
• Based on our experience, it is unusual for some investors to have a preferential right to withdraw from a fund ahead of other investors. Nevertheless, investors should ask fund managers if any investors have preferential redemption rights. It is also good practice to understand the rights afforded to and procedures required of all investors wishing to sell or transfer their interests if the need ever arises to do so.

Another series of potential conflicts related to preferential treatment accompanies a fund that primarily serves retail investors. Retail funds often invest alongside other institutional funds managed by the same manager. In these situations, potential conflicts generally relate to how investment opportunities are allocated between funds, whether related-party funds can buy investments from or sell them to the retail fund, whether the retail fund and related-party funds can each buy or sell investments at different points in time, and whether related-party funds can hold securities in a different part of the capital structure of a portfolio company (e.g., can a related-party fund own senior debt in a company in which the retail fund owns equity).

Most seasoned fund managers have developed policies and procedures to mitigate these conflicts, and they risk substantial reputational harm, breach of duty, regulatory fines, and possibly litigation if they do not follow them. Mitigating the risks does not mean, however, that the retail fund will be treated favorably when there is a conflict or have a favorable or even desired outcome. A fund manager may follow all of its prescribed procedures, address conflicts, and meet its duties, and the chips will still fall where they may. In short, mitigation measures assure a process but not a particular result.

• From a due diligence perspective, investors should understand the scope of potential conflicts from related-party funds, policies, and procedures that the manager has established to mitigate those conflicts and ask for examples of conflicts that have arisen and how they were resolved.

2. Reporting by Fund Managers

Many private funds in the U.S. already issue regular financial statements to investors and so the vacating of the Rules may not affect that practice. However, before investing, individual investors should ask their advisors whether the fund issues financial statements and at what frequency and whether individual investors can get access to them promptly. Investors should be cautious about investing with managers who do not provide these statements or do not engage well-known auditing firms with significant private asset experience. They should also ask if they can attend (in person or virtually) or get access to materials from investor meetings that the fund managers hold, or any other materials published or circulated about the fund. Those materials can be valuable sources of information on the progress of the fund, its investing, and any potential clouds on the horizon.

The Power Imbalance in Private Markets and What Individuals Need to Know

The recent Fifth Circuit opinion vacating the SEC’s Rules in their entirety has continued a trend in the US Supreme Court and certain other Federal Courts, turning agency rulemaking on its head. In the past, the courts deferred considerably to the authority and expertise of agencies to interpret statutes and issue evolving rules accordingly. That has changed. The ability of Federal agencies to promulgate new rules may slow or even stagnate. In the investment world, that will leave interested stakeholders to determine what they can and should do to understand and protect their interests as the courts curb agency authority and read statutes more narrowly.

While the Fifth Circuit’s opinion embraced the reasoning of the Private Fund Managers, some large public pension plans and associations of institutional investors supported the SEC in a brief. This means that institutional investors were important and perhaps predominant voices on both sides of this debate. They may prefer one outcome or another but are in a position to use their heft to advance their interests. Individual investors do not carry the same weight through collective action (except indirectly through pension plans and such) and so their interests and concerns may stay in the background for now. As such, individual investors need to be mindful of the relationships between fund managers, institutional investors, and private wealth advisors to recognize potential conflicts. And they need to stay informed about fund agreement terms to avoid being put at a material disadvantage relative to their fellow investors.