For Private Equity, the New Year Rings in New Regulatory Pressures

As dealmakers look to transaction in 2024, there is a host of new rules or proposed rules from various regulatory bodies that private equity firms need to either adhere to or keep a close eye on as the year unfolds.

“Regulatory requirements have grown under the current administration and have gotten more difficult to implement,” says Igor Rozenblit, a partner with Iron Road Partners, a consulting firm that helps private equity firms manage regulatory risk. “One reason might be the apparent shift away from selecting practitioners, who may be viewed as more ‘industry friendly,’ to selecting academics, who may not have a sufficient understanding of the impact of certain rules, as senior leaders at some federal agencies. This shift from practitioners to academics is new and unique to the Biden administration” Rozenblit focused on regulating private equity firms at the Securities and Exchange Commission prior to founding Iron Road Partners.

Additionally, with an election looming and macroeconomic uncertainty, Rozenblit does not expect relief from the current regulatory climate anytime soon. “In an election year, we often see more urgency around rulemaking as the administration considers the possibility of losing power. My advice to private equity firms would be to prioritize. You may not have the resources to focus on all the moving regulatory pieces, so dedicate your resources to implementing the regulations that are most relevant to your firm,” says Rozenblit.

My advice to private equity firms would be to prioritize. You may not have the resources to focus on all the moving regulatory pieces, so dedicate your resources to implementing the regulations that are most relevant to your firm.

Igor Rozenblit

Iron Road Partners

Here’s a look at some of the new regulations and rules being proposed or already being enforced.

Private Fund Advisers Rule

In August 2023, the Securities Exchange Commission (SEC) adopted a set of new private fund rules under the Investment Advisers Act of 1940, which may expand the regulatory compliance requirements for many private fund advisers.

Under the new rules, all registered private fund advisers are required to issue enhanced quarterly reports, disclose certain preferential treatment previously left to the side-letter process, perform annual audits of their funds and obtain a fairness opinion in adviser-led secondary transactions. Private fund advisers are also now restricted from engaging in certain activities without submitting to a complex disclosures and consent regime which may be difficult to for some managers to implement.

Since adoption of the rules and amendments, a group of private equity firms and hedge fund trade associations have sued the SEC, arguing that the SEC overstepped its regulatory authority. The petitioners have asked for resolution by May. “It’s hard to predict the outcome or impact of this litigation,” says Rozenblit. “Nevertheless, firms should be prepared to implement the new rules, even though they consider them burdensome.”

The most burdensome parts of the new rules include having to prepare and distribute various reports on expenses and investment performance 45 days after the quarter ends, and preparing disclosures to adhere to the new restrictions on preferential treatment contained in the rule. These requirements are in addition to the current requirement of preparing financial statements and valuations in the same timeframe. This is expected to be a big burden for middle-market and lower middle-market private equity firms that often have a very lean back-office staff responsible for all reporting requirements. These firms may have to hire more people, but are reluctant to do so without having the clarity of what will actually be required once the courts determine what regulations will remain intact.

“It seems very unlikely that the regulations will be totally tossed out in their entirely,” says Scott Gluck, Of Counsel in the Investment Funds and Private Capital practice at Paul Hastings. “A few of the more proscriptive provisions may be changed or eliminated, but I believe the reporting obligations are not going anywhere.

“This is all a lot for the smaller guys,” he adds. “They can’t just go out and hire more people to comply, but they also can’t bury their heads in the sand and pretend these new regulations aren’t coming. It will be a big scramble for many firms when the time comes to report.”

FTC Targets Roll Up Strategies

Add-on acquisitions have caught the eye of U.S. regulators who are looking more carefully for potential violations of antitrust laws. Add-on acquisitions have always been a big part of private equity firms’ strategies to grow platform companies.

In September, the Federal Trade Commission (FTC) sued U.S. Anesthesia Partners Inc. (USAP), a Dallas-based anesthesiology practice, and its private equity sponsor, Welsh Carson Anderson & Stowe, alleging that USAP and Welsh Carson engaged in a decade-long anticompetitive acquisition spree to cut options and drive up costs for consumers.

“There were a number of indications made by antitrust enforcement leadership warning that this was going to happen,” says Barbara Sicalides, a partner with Troutman Pepper, adding that the FTC issued a policy statement on unfair competition in November 2022. In June 2023, the FTC announced proposed revisions to its premerger notification rules, which would allow the FTC to look back at the add-on acquisitions made over a 10-year period (it had been a five-year period prior to the revision), and there is no longer a size threshold.

“It feels extreme. There are some Welsh Carson deals that only added three or five percent market share to the portfolio company. Based on the complaint and the new merger guidelines those small acquisitions can now be looked at and regulators can arguably attempt to go back to the formation of the platform company. The reasoning is there is concern when portfolio companies get so big in a single market. Companies can wind up having leverage with the payers. This could be an issue in the healthcare industry, but this rule is far reaching and not limited to healthcare,” says Sicalides.

Additionally, it’s unclear what role USAP’s arrangement with independent medical groups played in the FTC’s decision to challenge the roll-up or what the remedy will be if the court finds rolled-up companies are breaking antitrust rules. Some of the add-on acquisitions theoretically could have been made 10 years prior. As it stands, the courts will be left to decide.

“As for the Welsh case, Welsh is fighting the complaint aggressively and their challenges to the lawsuit are reasonable,” notes says Sicalides. “Once we have a ruling from the court on Welsh Carson’s motion to dismiss we will have a better sense of the risks to all private equity firms. Either way, private equity will want to be more careful about the risks they expose themselves to as they choose which deals to do and as they document their deal rationale and business plans.”

Proposed: Oversight Requirements for Services Outsourced by Investment Advisers

The SEC proposed a new rule and rule amendments to prohibit registered investment advisers from outsourcing certain services and functions without conducting due diligence and monitoring of the service providers.
The proposal would require advisers to satisfy specific due diligence elements before retaining a service provider that will perform advisory services, and to carry out periodic monitoring of the service provider’s performance.
Proposed: Safeguarding Advisory Client Assets

The rule, if adopted, would redesignate and amend the current custody rule. The proposed rules would broaden the application of the current investment adviser custody rule beyond client funds and securities to include any client assets in an investment adviser’s possession or when an investment adviser has authority to obtain possession of client assets. The new proposal would expand the rule beyond client funds and securities to include all assets — including art, cash, commodities, cryptocurrency and non-traditional assets — and require advisers to maintain those assets with a qualified custodian.

“This rule would require annual audits for all private funds, and eliminate the surprise examination alternative that some fund managers use,” says Gluck. “It would also require that essentially all assets must be with a qualified custodian. It would eliminate a viable alternative to audits that is utilized by a number of managers, and impose additional reporting requirements for firms that are already reporting so much.”

Proposed: Conflicts of Interest Associated with the Use of Predictive Data Analytics by Broker-Deals and Investment Advisers

The SEC is proposing new rules to eliminate or neutralize the effect of certain conflicts of interest associated with broker-dealers’ or investment advisers’ interactions with investors through these firms’ use of technologies that optimize for, predict, guide, forecast or direct investment-related behaviors or outcomes.

“Overall, it’s not a happy story,” Gluck notes. “More change and regulation is coming over the next year or two. There will be much more that has to be digested based upon what version of these proposed new rules are ultimately enacted. It is going to be a challenge for the overworked compliance and legal professionals at middle-market private equity firms for sure, but again, they can’t ignore it. You can’t afford not to be immersed in it because there is more coming down the pike.”

Danielle Fugazy is a freelancer writer covering private equity for more than 20 years. She is based in Glen Cove, New York.

Middle Market Growth is produced by the Association for Corporate Growth. To learn more about the organization and how to become a member, visit www.acg.org.