3 Areas of Private Equity the SEC Is Watching in 2023

The U.S. Securities and Exchange Commission continued to elevate its scrutiny over the private equity market in 2022, with new rules and proposals bringing an intensifying regulatory climate into the new year.

According to Molly Diggins, general counsel at advisor and placement agent Monument Group, “it’s clear that the SEC wants to regulate private equity markets to a much greater extent than they have in the past.”

The latest SEC initiatives within private equity center around transparency and investor protections. Collectively, says Diggins, these efforts signal the SEC’s desire to regulate the private equity sector more like public markets—an approach not likely to be welcomed by the PE community. “They’re regulating from a retail perspective, but it’s not retail investors who can invest in private equity,” she says, adding that this regulatory approach may lead to an overwhelming compliance burden—especially for midmarket firms.

Below, Middle Market Growth looks at three areas of private equity operations that the SEC is scrutinizing more closely in 2023.

It’s clear that the SEC wants to regulate private equity markets to a much greater extent than they have in the past.

Molly Diggins

Monument Group

1. Advertising Fund Performance

Early last November, the SEC’s new rules pertaining to how private equity firms can market funds to prospective investors came into effect. While firms had previously been able to promote past fund performance without deducting fees and expenses when advertising to prospective investors, the new rules will require the disclosure of such costs.

Although the SEC aims to improve transparency with the new rule, Diggins says its ambiguous language creates a “moving target” that can create a major hurdle to compliance. As written, the rule prohibits including “gross performance” in any advertisements, “unless the advertisement also presents net performance.” But that leaves plenty of room for interpretation, Diggins says: “Is it gross and net only at the fund performance level? Or is it deal-by-deal? How should we be portraying that, especially when, in some instances, net isn’t readily available or informative, even?”

The new rule could have a widespread impact on private equity marketing initiatives at a time when digital marketing is an essential tool in an increasingly competitive environment. “The private equity industry is evolving from mainly having one-to-one business development activities to incorporating marketing, which is a one-to-many activity that supplements and enhances business development and branding,” Farrah Holder, managing director of business development at IMB Partners, told Middle Market Growth for its special edition 2023 Multiples Report.

Diggins highlights the rule’s impact on placement agents like Monument, which must now amend existing contracts and placement agreements, and make disclosures to investors at the time marketing begins. Compliance has been particularly challenging for the PE firms that don’t usually employ placement agents and may therefore be unfamiliar with the new requirements, she says.

Despite the uncertainty, Diggins emphasizes that firms cannot afford to hold off on compliance. “They have to come to a reasonable interpretation of the rules and apply that consistently, and then have documentation to substantiate the course that they’re taking,” she says. But, she notes, it remains to be seen whether or not the SEC will agree on the various ways firms choose to interpret the rule.

2. Communicating Electronically  

Last year, Wall Street banks were hit with fines totaling nearly $2 billion after the SEC found the institutions fell out of compliance with federal recordkeeping rules when they failed to adequately monitor employees’ use of mobile and digital messaging apps to communicate with clients.

Now, the SEC seems to be setting its sights on the private equity community with similar enforcement goals.

Reports in Bloomberg Law last November said Apollo Global Management, Carlyle Group and KKR have each received letters from the SEC inquiring about the firms’ use of electronic messaging apps, including WhatsApp, Signal and Telegram. Of particular concern are the apps’ features that automatically erase messages, which may cause violations of recordkeeping requirements.

Federal authorities say the way PE firms regulate employee communications on third-party platforms is important when evaluating an overall compliance program. What’s more, access to digital communication records may be vital for firms’ cooperation during any criminal investigations.

While the SEC’s letters do not signal any wrongdoing (Apollo, Carlyle and KKR each have said they are cooperating fully with the SEC’s request), Diggins warns that for middle-market PE firms especially, any potential crackdown could be burdensome.

“It’s difficult to completely oversee,” she says of the challenge of monitoring employees’ external communication behaviors. “Firms have to make some decisions about how they want to enforce their own policies, and how to oversee the use of those different ways of communicating.”

Firms have to make some decisions about how they want to enforce their own policies, and how to oversee the use of those different ways of communicating.

Molly Diggins

Monument Group

One potential solution she offers is to require employees to have two phones that separate business from personal communication. But with private equity being such a relationship-based business, maintaining siloed communication channels won’t be easy. “The only real way to police it is to give everyone two phones, but even then, someone might be texting a client that you’re friendly with, and they want to go for a golf game, and end up texting on their personal number,” she says. “It’s a matter of training and periodically checking for compliance.”

3. Outsourcing Managers

The third area of SEC enforcement that private equity firms should be watching closely is in outsourcing. A proposed rule, announced in October, would elevate due diligence requirements for investment advisors, which would need to conduct background checks as well as periodic performance monitoring of any outsourced function that is “necessary for the investment advisor to provide its investment advisory services.” It’s a broad definition that can include client services, investment management and more.

If enacted, more middle-market private equity firms could find themselves impacted significantly by this rule as the popularity of outsourcing grows. “Outsourcing plays a large role from a time-to-value perspective,” said Bain & Co. partner Kunal Mehta during the “Outsourcing Strategies to Improve Value Creation” panel at ACG’s virtual Operators’ Summit held last year.

Related content: Where, When and How to Outsource

Outsourcing key functions like investment management can drive value, especially for mid-level firms with limited resources that may not always be able to hire in-house. But Diggins warns that this proposal is an example of how SEC efforts to protect investors and improve transparency are placing a disproportionately large compliance burden on mid-market PE firms.

“It raises the bar for due diligence requirements for managers on anyone to whom they outsource, especially with respect to investment management,” she says.

The proposed rule is especially concerning for private equity firms that worry the SEC’s regulatory approach could signal an eventual effort to open up PE to retail investors. Having more small-scale investors in a fund, as opposed to a few larger investors, increases due diligence burden, especially on middle-market firms that increasingly outsource investment managers.

“It would be great if we could have retail investors and smaller investors in the kinds of funds that we raise,” Diggins says. But doing so would mean a level of Know Your Customer (KYC), Anti-Money Laundering (AML) and other compliance checks that middle-market firms don’t always have the resources to handle. “They would much rather have one big institutional investor than 30-40 smaller ones, because they just can’t afford the kind of back office that you would need to have.”

“By having the focus by the SEC on making it just like retail in terms of regulatory requirements, you’re not helping anyone,” she continues. “You’re just squeezing out mid-market managers.”

Carolyn Vallejo is Middle Market Growth’s digital editor.