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Private funds prepare to spend billions on compliance after SEC rule

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Private equity, venture capital and hedge fund groups are preparing to spend billions of dollars on compliance and legal advice as they cope with the biggest regulatory changes to hit the industry since the aftermath of the 2008 crisis.

The US Securities and Exchange Commission’s decision last month to adopt sweeping new rules for the private fund industry is prompting some smaller fund managers to look for their first full-time general counsels and chief compliance officers.

Larger firms are considering not only whether to recruit more staff, but also the need for different kinds of lawyers in light of new rules that will change the way they interact with their investors. And the entire industry is gearing up to invest more on compliance and reporting technology.

“This is something keeping general counsels up at night. Private funds’ legal teams are very thinly staffed,” said Allison Rosner of recruiters Major, Lindsey and Africa. She said she had heard from several general counsels: “I need a clone or a mini-me.”

The SEC estimated as part of its rulemaking process that new requirements for audit statements and quarterly performance reports would cost the industry $961mn annually. Regulations on unequal treatment of investors, as well as extra staff and legal costs connected to disclosures around fund expenses, would cost another $938mn.

Those costs do not include increased spending on tougher marketing rules that firms had to start complying with late last year as well as new “form FP” amendments that require rapid regulatory disclosure of big losses and other important events.

Private fund managers bent on staffing up are likely to poach from legal and compliance departments at traditional asset managers and banks, as well as from the SEC itself. Headhunters say they are getting requests for compliance experts who will be comfortable explaining to portfolio managers and investors the new rules on disclosure and consent.

“Stakeholder management is increasingly sought after by the business as they bring in new compliance and risk management people,” said Ellen Yaffe, a partner in Russell Reynolds’ financial services practice. “Funds are going to want fees to be explained in ways that clients accept them.”

The spending and recruitment plans are moving forward even though six industry groups have filed suit to stop the new private fund rules from going into effect. Firms are concerned that the case might still be pending or that a court loss would leave them unprepared to implement the new rules by their effective date, expected to be in roughly a year to 18 months, depending on fund size.

Much of the spending will be front loaded, much as it was a decade ago when the industry had to comply with rules forcing private funds to register with the SEC. Firms are expecting to have to set up computer systems to track valuation, expenses and special arrangements with individual investors, known as side letters.

 “A lot of smaller managers already spend a large portion of their operating budgets on compliance. This will increase barriers to entry,” said Michael Hong, a partner at the Davis Polk law firm.

Fund managers will have to figure out how to comply with a mandate for investors to be treated similarly for redemption and disclosure purposes even when they are not in identical funds. The SEC has specifically warned the industry that treating investors in a healthcare fund and a tech fund differently could violate the ban on preferential treatment.

“Managers are left having to manage the process to make sure that everybody gets the information they want, but no one gets preferential information. People will be feeling their way through that,” said Jennifer Wood, who heads up regulation at the Alternative Investment Management Association.

Managers who sell shares to investors in funds that have already completed their fundraising, known as adviser-led secondaries, will also have to spend additional money on third-party valuation or fairness opinions to make sure investors know what they are buying. The SEC estimated that 10 per cent of funds offer secondaries annually.

The whole compliance process will be complicated by another SEC pending proposal that would tighten requirements for outsourcing functions from custody to tech, lawyers said.

“It’s hard to build a scaleable system when you don’t know what else is coming down the pike,” said Marc Ponchione, a partner at law firm Debevoise & Plimpton. “In combination, these are not plug-and-play rules.”

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