Neither GPs nor LPs seem to be particularly satisfied with the way LP advisory committees (LPACs) function. In 2019, the Institutional Limited Partners Association (ILPA) issued its Principles 3.0, which optimistically observed that the “[PE] industry has made meaningful strides in instituting standardized approaches to [LPACs].” Yet recently, an Institutional Investor article asked, “These Boards are Meant to Protect PE Investors. Why Can’t Anyone Agree on How?” “Each of these is kind of a negotiated deal. There’s no industry standard,” the article quotes an institutional investment manager, noting – without irony – that this individual “sits on about 60 LPACs.” When the SEC adopted the since-vacated private fund adviser rules, the agency had no illusions about the effectiveness of LPACs:

[T]hese types of bodies may not have sufficient independence, authority, or accountability to oversee and consent to these conflicts. Such LPACs . . . do not have a fiduciary obligation to the private fund investors. To the extent investors are afforded LPAC representation or similar rights, certain fund agreements may permit such investors to exercise their rights in a manner that places their interests ahead of the private fund or the investors as a whole. For example, certain fund agreements state that . . . LPAC members owe no duties to the private fund or to any of the other investors in the private fund and are not obligated to act in the interests of the private fund or the other investors as a whole.

Dissatisfaction with current LPAC practices is not limited to under– or unrepresented LPs. As LPACs have evolved from serving advisory roles to performing a range of approval rights, GPs’ frustrations with delays and other dysfunction in the decision-making process have grown correspondingly.

This article argues that the inclusion of independent members on the LPAC – i.e., members that are not affiliated with the GP or any LP – would address a number of the deficiencies in current LPAC practices, resulting in improvements to fund governance practices that would inure to both GPs and LPs.

See “LPAC by Design: Six Recommendations for GPs to Define LPAC Features During Fund Formation” (Feb. 25, 2020).

Current Practice and Deficiencies

LPAC Composition

GPs typically grant LPAC seats to LPs who request them at the fund formation stage and have the negotiating leverage to insist on their request being accepted. The leverage usually derives from the size of an LP’s commitment to the current fund, the amount of the LP’s aggregate commitments to several funds managed by the GP and the prospect of the LP issuing larger commitments to future funds. Despite ILPA encouraging GPs and LPs to allocate seats to ensure the LPAC represents the diversity of the LP base at large, in reality, LPACs rarely do. The only ILPA recommendation that seems to be followed in practice is that LPACs do not include representatives of the GP or its affiliates.

Although there was a time when LPACs became unmanageably large, they now mostly seem to comprise 5‑15 members. As funds frequently have hundreds of LPs, that means the vast majority of investors are not represented on the LPAC. In addition, LPs with large commitments are often among the largest LPs in multiple funds and thus represented on multiple LPACs, with corresponding attention deficits. The fact that one individual sits on 60 LPACs – as referenced in the aforementioned Institutional Investor article – should give pause to the entire industry.

Each LPAC member generally has one vote, and matters before the LPAC are approved by majority vote. In other words, voting power is not proportional to capital commitments.

See “Evolution of LPACs: Trends Toward Robust Procedures and Accountability for LPAC Members (Part One of Two)” (Oct. 8, 2019).

Scope of Approval Rights

The shortcomings in how LPACs are structured and operated have become more apparent – and the need for improvements has gained urgency – as the scope of approval rights granted to LPACs by fund agreements has increased over the last few years. They typically include:

• affiliate transactions;
• investments in excess of concentration or other allocation limits (e.g., geographical restrictions);
• investments outside the defined investment focus;
• key person successions and GP ownership changes;
• extensions of commitment periods and fund terms;
• waivers of thresholds when launching successor funds; and
• the incurrence of fund debt outside permitted parameters.

LPACs’ approval of affiliate transactions is particularly growing in importance as the volume of continuation funds has steadily increased, along with the ongoing consolidation of portfolio companies held by different funds of the same GP and other interfund transactions.

Conflicts of Interest

The SEC was correct in its observations about the limited duties of LPAC members. Fund agreements consistently provide that LPAC members do not have fiduciary duties and, as long as they act in good faith, they can place the interests of the nominating LP ahead of the interests of the fund or the other LPs.

One of the most frequently noted deficiencies is the way LPAC members’ conflicts of interests are addressed. ILPA’s Principles 3.0 recommend:

Either the GP or the LPAC member in question should disclose when an individual LPAC member has a conflict of interest that relates to the matter under consideration, e.g., the LPAC member being a potential lender to a portfolio company, co‑investment for secondary investment activity alongside the fund, investments in prior funds, ownership of an interest in the management company, etc. GPs should remind LPAC members of relevant conflicts of interest prior to votes being held.

See this two-part series on ILPA’s Principles 3.0: “PE Economics and Related Fund Provisions” (Jul. 30, 2019); and “Fund Governance and Disclosures” (Aug. 6, 2019).

It is easy to add more examples of conflicts of interest to ILPA’s list. For instance, an LP planning to invest in a continuation fund may also be represented on the LPAC of the exiting fund. Also, large LPs are often represented on the LPACs of successive funds, which places them on both sides of interfund transactions.

Notably, ILPA’s recommendation to disclose conflicts of interest is not followed with any consistency. A main reason is that the consequences of any disclosure are unclear, as are the consequences of any failure to disclose. Not even ILPA recommends that LPAC members recuse themselves from voting on matters for which they have a conflict of interest. Further, failure by an LPAC member to disclose a conflict does not affect the validity of his or her vote.

Complaints that LPAC practices lack standardization miss the point, as the practices described above are actually quite uniform across funds and their managers. The real issues are LPACs’ inherent structural deficiencies: no representation of a majority of LPs, no fiduciary duties and no protocol for mitigating conflicts of interest.

See “Evolution of LPACs: Grappling With GP and LPAC‑Member Conflicts of Interest While Avoiding Liability (Part Two of Two)” (Oct. 15, 2019).

LP Dissatisfaction

If conflicted LPAC members, regardless of disclosure, can still vote without the confines of fiduciary duties, then disclosure is merely a courtesy rather than a requirement. The result is that non-member LPs are forced to bear the consequences of the industry’s dismissive treatment of LPAC conflicts of interests.

For example, the Institutional Investor reported that “LPs are often left to find out themselves what conflicts exist,” and quoted a frustrated investor who lamented, “we’re invested in just this fund, not all funds[,] . . . [but] have to think about what other LPAC members are doing because they may be invested in three funds.” In addition, anecdotes abound about LPAC members’ reluctance to participate in crucial decisions out of fear that may expose the appointing LP to GP liability, which slows down decision making.

Benefits of Independent Members

Although there is no data available on the point, anecdotally it seems that current LPACs rarely, if ever, include independent members. The reality, however, is that the inclusion of one or two independent members with PE experience on an LPAC would address or at least mitigate the inherent deficiencies of historical LPAC practices.

Independent LPAC members would likely add value to the process in multiple ways:

• improving communication among LPAC members, as well as between a GP and the LPAC;
• adding an objective perspective; and
• accelerating the speed of decision making.

To better understand the potential value of including independent members as LPAC members, it is helpful to consider private company boards. In KPMG’s “2023 Private Company Board Survey Insights,” nearly 90% of respondents said that their boards included at least one independent director, which was defined as a director who is not an executive and not affiliated with the company through an ownership interest.

The following chart shows the KPMG survey results in response to the question “Where do you believe an independent director can add the most value to the business?,” together with an annotation for the potential application to independent LPAC members.

KPMG Private Board Survey		Potential Application to Independent LPAC Members
Serving as a sounding board for executives.	77%	Yes. GPs may be more inclined to test the waters with an independent member before taking a matter to the full LPAC.
Advising on strategy.	75%	Potentially. Consistent with an LPAC’s function, its independent members should not get involved in investment strategies. Independent members can, however, weigh in on strategic matters affecting the fund itself – e.g., when to launch a successor fund or how to approach co‑investment opportunities.
Balancing the views of management and owners with an independent perspective.	75%	Yes, in the sense that LPs own the fund and independent LPAC members can mediate between LPs and the GP.
Helping to improve board effectiveness, functioning and process.	51%	Yes. Independent LPAC members can act without fear of exposure to GP liability.
Focusing an oversight of financial reporting and risk management.	45%	Unlikely. LPACs are involved in valuation questions, but independent members should not have an incremental role compared to the full LPAC.
Overseeing CEO succession.	43%	Unlikely. The equivalent would be key person successions, but independent members should not have an incremental role compared to the full LPAC.
Serving as a board committee chair.	23%	Potentially, for example, if the LPAC forms a committee in connection with a continuation fund or interfund transaction.
Serving on a special committee.	19%	Potentially. See above.
Serving as board chair.	16%	Potentially.

An equally important benefit is that independent LPAC members give a voice and sense of participation to LPs that are not represented on the LPAC. As independent LPAC members are not representatives of any particular LP or group of LPs, unrepresented LPs will perceive them as adding credibility to fund governance. Therefore, independent members should have fiduciary duties, although those should be limited to exercising the specific functions assigned to the LPAC by the fund agreement.

Practical Considerations

The first and most obvious concern that would likely be raised about including one or two independent members is whether that would shift the voting power of the body. It should be apparent, however, that their inclusion would not meaningfully shift the voting dynamics of an LPAC with 5‑15 members. Independent LPAC members can effectuate change without controlling the entity’s voting power because the vote itself is not necessarily what matters but, rather, the discussion preceding the vote.

With that said, there are several material factors and considerations that LPs and GPs need to thoughtfully consider as they move forward with including independent members on their funds’ LPACs.

See “Former Law Firm Partner and Current Independent Director Provides Perspective on Private Fund Governance Issues, Regulatory Matters and Allocator Concerns” (Oct. 27, 2016).

Compensation

A main obstacle to appointing independent LPAC members may be the mutual reluctance of GPs and LPs to bear the compensation, but the magnitude of that issue can be gleaned by evaluating boards of privately held companies. In a 2022 survey of private companies, 70% of which were wholly owned or majority-owned by families, Compensation Advisory Partners found that:

• annual retainer fees correlate to company size, with a median of $65,000 for companies with over $1 billion in annual revenues and a median of $30,000 for all companies;
• 27% of companies paid meeting fees, with a median in‑person meeting fee of $2,500 and a median virtual meeting fee of $1,000; and
• 26% of companies offered long-term equity incentives to independent directors.

The issuance of equity incentives is unlikely to be feasible for LPAC members, as that practice is more prevalent among PE portfolio companies.

A valid parallel between companies and funds, however, is the correlation to size. A survey by Gallagher, another benefit consulting firm, observed a median annual cash retainer of $75,000 for outside directors of large family-owned companies. As a company’s revenues increase, so do the responsibilities of the board, and independent director fees are correspondingly higher. Therefore, it is reasonable to suggest an annual cash retainer fee for independent LPAC members in the $25,000-$75,000 range, depending on fund size and other variables that impact complexity and responsibilities.

GPs and LPs need to ask themselves: do the benefits of independent LPAC members warrant these costs? Considering the deficiencies of current practices, LPs’ dissatisfaction with overall fund governance and the opportunity for GPs to distinguish themselves through innovation, the answer should clearly be “yes.”

Selection Criteria

To be considered independent for these purposes, an LPAC member should not:

• be an investor in any fund managed by the GP in question;
• be affiliated with any GP in the PE industry – not just the GP for the fund in question;
• be affiliated with any LP in any fund managed by the GP in question;
• be affiliated with any institutional LP that invests regularly in PE; or
• serve on the LPAC of any other fund managed by the GP in question.

Who are likely candidates? They should be professionals with PE experience, but the relevant experience relates more to the nuances of fund dynamics and less to the investment focus of the fund. The combination of PE experience and the aforementioned independence standards points toward investment professionals who, due to career change or retirement, are no longer affiliated with a PE firm or institutional investor, as well as former PE lawyers and similar service professionals.

Who should appoint an independent LPAC member? The initiative needs to come from the GP, but one can imagine different appointment processes. For example:

• the GP names the independent LPAC member(s) in the fund’s offering materials;
• after the fund’s first or final closing, the GP nominates the independent LPAC member(s) who must then be approved by the other LPAC members; or
• the GP nominates, say, two candidates for each independent LPAC seat, and the other LPAC members select between the proffered candidates.

Will candidates be concerned about the risk of legal liability associated with fiduciary duties? Yes, but not more than professionals who consider joining a public or private company board. Potential LPAC members should get comfort from the fact that they are indemnified under fund agreements and covered by GP liability insurance policies.

See “Navigating Indemnification and Exculpation Provisions in Fund Documents (Part Two of Two)” (Nov. 2, 2021); and “How E&O and D&O Liability Insurance Can Help Fund Managers Mitigate the Consequences of Regulatory Enforcement Actions” (Jun. 2, 2016).

Conclusion

With all the anticipated benefits of independent LPAC members, why has it not happened yet? Conversations with GPs indicate that the answer has less to do with any particular objections or obstacles, and more with the simple fact that they had not thought about it. LPACs in general are rarely the result of deliberate design.

There is reason to believe, however, that the inclusion of independent members on fund LPACs will quickly become the industry standard after one or a few prominent GPs either include them in the LPACs of their new fund launches or add them to their existing LPACs, as permitted. The cost-benefit analysis clearly points in that direction.

 

Robert Seber is a partner in the PE group of Vinson & Elkins LLP, where he heads the firm’s fund formation practice.

Amidst an unprecedented flurry of enforcement actions and fines levied by the SEC for off-channel communication violations, some investment advisers have raised concerns that emojis and video conferencing platforms will be the next frontier for regulatory scrutiny. Unfortunately, the current suite of technology solutions for monitoring, capturing, and retaining emojis and video communications remains imperfect. There are, however, reasons for optimism, both in terms of approaches compliance professionals can take to mitigate those potential risks and the forecast for how regulators might treat those communication mediums going forward.

This second article in a two-part series identifies challenges that emojis and video communications present for advisers attempting to record, retain and monitor those forms of technology, and suggests how advisers can bolster their corresponding compliance efforts. The first article offered an overview of the SEC’s ongoing scrutiny of off-channel communications to date, and contemplated why emojis and video communications may be areas targeted by the Commission and other regulators in the future based on recent comments and legal developments.

See our three-part series on electronic communications: “Current Technological Landscape and Relevant Regulatory Measures” (Jul. 13, 2021); “Useful Training Techniques and Policies and Procedures to Adopt” (Jul. 20, 2021); and “Using Third Parties for Compliance, Mitigating Social Media Risks and Fulfilling Document Requests” (Jul. 27, 2021).

Challenges Posed by New Technology

It is crucial for investment advisers to properly handle emojis and video conference-based data in light of the SEC’s ongoing sweep of off-channel communication violations; the growing importance of those communication mediums in litigation and enforcement; and the increased interest and scrutiny expressed by FINRA and the SEC. Unfortunately, monitoring, retaining, and interpretating emojis and video communications poses distinct challenges that fund managers need to grapple with.

Emojis

At FINRA’s annual conference in May 2023, its head of examinations, Michael Solomon, suggested that members must consider emojis and other novel forms of communication in their written procedures for off-channel communications. The comment elicited audible groans and pointed questions from the audience, which is understandable given certain complexities posed by emojis.

Proliferation and Interpretation

In addition to being open to a wide variety of (often competing) interpretations, the number of emojis are proliferating. The most recent update to the Unicode Standard for digital text in September 2023 added 118 new emojis, including two different directionalities of head shake and a broken chain. The number of Unicode-recognized emojis is nearing 4,000 – a total that does not include those that are not universally recognized, and which may be incompatible with other apps and platforms. For instance, Unicode supports but does not recognize the Texas flag emoji, which can only be used on WhatsApp.

In addition, emojis can appear radically different depending on a user’s operating system. Apple, Android, Google and Microsoft each use different sets of artwork to render the same standard emojis, meaning they can look different depending on the app or hardware being used – possibly appearing differently on two devices within the same organization, or differently to the sender than to the recipient. Those subtle changes in artwork may also have an impact on how they are received and interpreted – and collected, stored and searched by compliance personnel.

Technological Limitations

Current technology used by compliance personnel to monitor, review and retain a firm’s electronic communication often fails to support one or more of the requirements to collect, store and search emojis. “Emojis often display as unidentified on a review platform,” said Willkie Farr partner Adam S. Aderton. “They might all display as just a stock image and not the actual emoji.”

Even systems that can capture emojis may have significant limits. “Understanding communications in context has been a really serious challenge for firms historically,” noted Sidley Austin partner Stephen L. Cohen. “You’ve got to capture the data with all the fidelity and context.” Instead, legacy compliance tools that can collect and retain emojis often strip them from the context in which they are used. “To the extent the software can actually capture emojis, if at all, it effectively turns them into something like an email attachment such that the emoji itself might not be in line with the actual communications,” he explained.

The same lack of context also hampers many existing search functions when it comes to emojis, Cohen continued. “Lexicon-based approaches are effectively a thing of the past,” he asserted. “The context around emoji usage is so important for understanding where a conversation is related to a particular product or service, or where the conversation seems indicative of some type of prompt.”

Video Communications

Compliance personnel face many of the same problems as with emojis when attempting to collect, retain and search data from video conferencing and other collaboration platforms. Even if an investment adviser chooses not to record and save the audio-visual data from those communication sources, it will still likely run into difficulties capturing and retaining the text-based features that many offer (e.g., chat, questions-and-answers, screen sharing, whiteboards and polls).

Should a firm wish to go above and beyond by recording the video, the technological issues only increase. “Think about the capacity and necessary supervision of that kind of regime,” Cohen suggested. “Imagine the data involved with recording all Teams meetings or all WebEx meetings. I’m not sure that the juice would be worth the squeeze.”

Worse, it may undermine the very benefits of using those video conferencing and collaboration platforms. There would likely be a “chilling effect” from the widespread practice of recording and retaining video conferences for compliance purposes, Cohen warned. “People don’t like to be recorded – not because they’re afraid of being caught violating the law, but because they want to be casual or loose when brainstorming. They don’t want to be judged or held accountable for their creative thoughts and discussions.”

There may also be privacy concerns around retrieving text-based data from employees’ personal devices. Earlier this year, a former employee sued a fund manager for accessing his home computer following his termination. Investment advisers have to walk a fine line, however, as they could potentially face liability for failing to access personal devices to preserve off-channel communications. For example, the SEC found Senvest Management, LLC liable for “not [accessing] employees’ personal devices to determine whether they were complying with the firm’s communication policies.”

See “SEC Brings First Enforcement Action Against a Stand‑Alone Investment Adviser for Off‑Channel Communication Violations” (May 30, 2024); and “Private Fund Founder Challenges Firm’s Post‑Employment Access to His Home Computer” (Feb. 22, 2024).

Still, Seward & Kissel partner Michael Watling emphasized, “we are not advising people to seize personal phones and go searching through them.” Instead, firms may need to take certain measures to bolster their ability to access data on employees’ devices, such as by limiting employees to using company-owned devices or by performing routine backups of company-owned equipment, information systems and communications.

Compliance Suggestions to Consider

Navigate Usage Restrictions

Given the challenges inherent in attempting to record, retain and monitor fast-evolving technologies on rapidly-changing platforms, simply restricting their use – by turning off features such as chat or polling that might trigger recordkeeping requirements – is certainly appealing. “There is a potential benefit in being able to represent to a regulator that there were no chat communications because we’ve disabled the chat functionality of a video call,” Aderton observed.

In lieu of the most draconian approach of outright eliminating otherwise useful features, some firms pursue alternative approaches to mitigate the risks posed by off-channel communications. For example, most firms prohibit the use of disappearing or “ephemeral” message apps, and many employ email signatures that ask recipients to use the listed cell phone number only for voice and not for text.

With that said, restrictions, prohibitions and limitations are only successful to a limited extent. For example, J.P. Morgan settled parallel investigations of off-channel communication violations with the SEC and CFTC in December 2021, Watling noted. Both settlements explicitly acknowledged that the firm had policies and procedures in place forbidding the use of off-channel communications. “Nonetheless, the agencies still imposed civil penalties in the aggregate of $200 million,” he observed.

See “Electronic Communications, Cooperation Standards and Other Emerging Trends in the SEC’s Oversight of Private Funds” (Jan. 12, 2023).

Further, overly broad prohibitions have the potential to backfire. “My view is that attempts by firms to restrict their personnel from using certain communication channels or platform features is what prompts those employees to pursue off-channel behavior in the first place,” warned Marc G. Gilman, GC and vice president of compliance at Theta Lake.

Instead, Gilman recommended that advisers carefully choose core platforms and then allow employees to use them with as much freedom as possible. The best approach is to enable emojis, attachments, animated GIFs and other features so that the platform really has the look and feel of any other consumer platform your employees might be using, he asserted. “That approach gives employees effectively everything they need to communicate and reduces their desire to go outside of the firm-approved channels.”

In addition, that approach allows firms to get the most value from the communication platforms they pay for, Gilman continued. “Enabling employees to use all the tools at their disposal to the fullest extent can be a significant force multiplier for companies,” he argued. “What’s really driving the conversation is strategic technology enablement rather than retention cost.”

See “Crafting Effective Mobile Device Policies to Satisfy Regulatory Expectations” (Jul. 11, 2024).

Adopt Robust Policies and Procedures

Whatever the approach chosen, firms must ensure their rules around the use of approved platforms are clear for their employees. “Put policies and procedures in place that ensure people understand,” Gilman stated. “Whether the policies are discussing the use of emojis or approved methods for distributing marketing materials, employees absolutely must receive guidance about how to use the firm’s communications platforms.”

That is particularly true – and fraught – when it comes to recording video. Current laws and regulations do not require sponsors to record and retain video communications. If, however, a firm chooses to record any specific video communications, then that firm needs to be very thoughtful about whether and how that is described in its handbooks, policies and procedures. “Fund managers could almost create a violation for themselves from a policy perspective,” Aderton cautioned. “They may violate Rule 206(4)‑7 under the Investment Advisers Act of 1940 (Advisers Act) if they are not following their policies and procedures.”

Whatever policies and procedures are ultimately adopted by advisers as to emojis and video communications, one thing must be abundantly clear: “You have to say out loud and with sufficient regularity that retention of all business-related communications is non-negotiable, and there is a zero-tolerance policy for it,” Watling emphasized.

See “Ongoing SEC Sweep Targets Advisers’ Off‑Channel Electronic Communication Recordkeeping Practices” (Mar. 9, 2023).

Conduct Regular Training

On their own, written policies and procedures are insufficient to protect a firm from risks posed by emojis and video communications. For example, a firm’s employee handbook is not going to include detailed interpretation of the meanings of several thousand emojis. Instead, the task of explaining the nuances and risks of using emojis, as well as new collaboration platforms with or without video capabilities, is best addressed through regular training sessions for employees.

“Advisers are going to rely on training employees to understand that emojis are communication that can be – and will be – subject to misinterpretation, particularly by regulators and other authorities,” Aderton said. “In particular, emojis are likely to be looked at with skepticism by regulators who may infer a nefarious meaning from the use of particular emojis.”

See “High- and Low-Tech Innovations for Fund Managers to Overcome Compliance Training’s Drawbacks” (Feb. 1, 2018).

When training employees on the firm’s policies and procedures as to off-channel communications, it also behooves fund managers to obtain written attestations from their employees whereby they acknowledge that they understand what is expected of them. “People need to be attesting at least annually in compliance questionnaires that they are obeying the rules,” Watling suggested.

Avoid Recording Video Communications

It is reasonable to extrapolate from the SEC’s enforcement actions targeting off-channel communication violations that video communications seem like a natural concern for regulators, Cohen said. It is worth noting, however, that there is no specific rule or requirement under the Advisers Act that requires advisers to preserve any video communications by employees. In light of that, the experts interviewed by the Private Equity Law Report agreed that the best policy when it comes to recording audio-visual material is to simply avoid it altogether.

Beyond the lack of any affirmative recordkeeping requirement, there are a number of good reasons why advisers should avoid recording video conferences. The most pertinent is that, if video communications are recorded and retained, they would have to be turned over in an examination or investigation. Despite there being no legal obligation under the Advisers Act to record video communications, document request lists delivered by the SEC’s Division of Examinations have asked for any recordings that do exist, Cohen noted.

See “SEC Risk Alert and Accompanying Checklist Explains Examinations Process and Identifies Key Documents to Have Ready” (Nov. 2, 2023).

With that said, it should be somewhat reassuring for fund managers to know that a rule adding video recordings to recordkeeping requirements under the Advisers Act is unlikely to be forthcoming. “If the Commission concludes that recorded meetings or calls should be retained, then the agency has the ability to adopt a corresponding rule and it simply hasn’t done so yet,” Aderton clarified.

Beyond concerns about whether such a rule would fit within the scope of the Commission’s authority under the Advisers Act, the real issue is that a video retention requirement would probably fail a cost-benefit analysis. “Rules can always be supported in terms of potential for catching misconduct, but that’s not a singular question. What’s the cost of recording every video in the modern age in dollars and human cost?” Cohen queried. “It would be odd that a Zoom call would be required to be recorded, but you are not required to have a camera for an in-person meeting. You don’t have a drone following you around recording conversations.”

Improve Overall Technology Capabilities

The technology needed to capture emojis with fidelity, as well as to collect and retain all written communications on novel collaboration and video conference platforms, remains inadequate, but is slowly improving. “With each passing day, vendors are creating better products and companies are coming up with smarter solutions to track all of this,” Watling offered. “I think the evolution point is still another 24 months from now: hopefully by then we will all be comfortable with the ways that banks, broker-dealers and advisers are using technology to track off-channel communications.”

See “Designing a State-of-the-Art Private Fund Compliance Department: Leveraging Cutting-Edge Technology” (Sep. 21, 2023).

Although emerging technology solutions may use artificial intelligence (AI) or machine-learning capabilities to help companies determine when an emoji winking face is simply innocent in context, it is incumbent that advisers take proactive steps to reduce compliance risk in the near term, Gilman asserted. “Firms must lay the foundation for effective supervision by ensuring that all the dynamic elements of conversations like emojis, attachments, edits, GIFs and deleted communications are appropriately captured, and then they can layer in AI‑based capabilities to enhance their existing processes” he noted. “Examples of foundational steps can include bolstering policies and procedures, conducting more employee training or upgrading existing technology platforms to expand and improve the communications they capture.”

Enter Into Client Communication Agreements

A novel approach fund managers can adopt to limit off-channel communications and their risks is by targeting not only their own employees, but also those with whom they might correspond on unauthorized platforms. To that end, some advisers have included provisions in agreements with third-party vendors, or entered into client communication agreements with their investors, requiring them to commit to not using off-channel communication platforms to correspond with the advisers’ employees.

See “Managing Risks Associated With Outsourcing” (Nov. 2, 2023).

Conclusion

The experts interviewed by the Private Equity Law Report are in broad agreement that regulators are not yet focused on emojis or video conferencing on their own, or as part of their ongoing crackdown on off-channel communications. “Everyone is really spooked by all of the SEC’s enforcement activity targeting electronic communications, and these are two potential areas where they could have additional concerns,” Cohen allowed. “Rest assured, however, that for several reasons this does not seem to be an issue. That result may be a little anti-climactic, but it is not useless.”

As the SEC’s enforcement sweeps eventually wind down, however, compliance practices around retaining emojis and video communications may become greater areas of focus. “We are probably getting to the later innings of leveling up those compliance policies and procedures,” Aderton argued. “Perhaps going forward regulators will have more bandwidth to think about these questions about emojis or other forms of communication.”

Hybrid funds have become increasingly popular as sponsors look for creative ways to provide more flexibility for investors and address issues that can limit traditional open-end and closed-end funds. Although the evergreen nature of hybrid funds can save managers time from having to constantly fundraise, they also present an array of conflicts of interest and complications that need to be weighed and mitigated.

The Practising Law Institute recently hosted a panel on hybrid funds as part of its Advanced Issues in Private Funds 2024 program. The panel was moderated by Cleary Gottlieb partner Maurice R. Gindi, and featured Matthew Jill, partner and GC, private funds and secondaries at Ares Management (Ares); Barbara Niederkofler, partner at Akin; and Amelia Stoj, CCO and assistant GC at Foresite Capital.

This first article in a two-part series discusses the fundraising benefits and challenges presented by hybrid funds, as well as several types of liquidity mechanisms that managers can wield to meet their LPs’ withdrawal needs. The second article will analyze other features and considerations when operating a hybrid fund, including as to LP discussions, operational challenges, management fees, carried interest, clawbacks and conflicts of interest.

For additional insights from Niederkofler, see “Eleven ‘Top of Mind’ Questions and Misconceptions Surrounding the New Marketing Rule” (Mar. 22, 2022); and from Gindi, see “PE in a Recession: Tips for Tailoring Fundraising Efforts, Anticipating Demand for Secondaries and Managing Co‑Investments (Part One of Three)” (Sep. 20, 2022).

Overview

Historically, funds have been established with an open-end structure if they intended to invest in liquid assets, while closed-end structures were used when the investment assets would be illiquid, Gindi said. There is growing appetite, however, for funds that target both liquid and illiquid assets, as well as fund structures that do not necessarily fit within the traditional paradigm, he added.

There is no single definition for a hybrid fund, but for ease of reference it may simply be considered a private investment vehicle that encompasses elements of more liquid hedge fund structures and more illiquid PE structures, Niederkofler noted. When structuring hybrid funds, it can be useful to think about a basket of tools that are selected to suit the strategy, underlying assets and capital raising efforts, she suggested.

Theoretically, hybrid funds may be used for any type of asset, but they seem to work best when assets produce regular cash flows (e.g., private credit and core real estate) and turn over on a two- or three-year lifecycle, Jill explained. Although managers tend to focus on areas where hybrid funds seem best suited, there are hybrid funds in the market focused on PE and private real estate strategies, he noted.

The target assets will influence how the hybrid fund is structured and where on the spectrum it sits, Niederkofler observed. For example, a hybrid fund with more illiquid assets may include liquidity events for investors at specific times, whereas a fund with an income stream may allow investors to move in and out more easily, she elaborated.

See “Sidley Panel Discusses Operational and Tax Challenges of Hybrid Funds” (Nov. 5, 2019).

Fundraising

Benefits

Hybrid funds can provide fund managers with more flexibility and agility to react to market changes, Jill noted. For example, if there is a rapid influx into the alternative credit space, then a closed-end fund that has just closed would be unable to respond as quickly as a hybrid fund that can approach that market in a more ad hoc manner, he asserted.

Further, the evergreen nature of hybrid funds is particularly appealing to fund managers. The process of raising sequential funds is difficult due to the increase in regulatory requirements, as well as the significant comments received when offering to a large investor base, Jill continued. The current fundraising environment exacerbates those challenges, Niederkofler added, particularly as investors are making commitments with fewer GPs. As it is becoming less appealing to raise funds from scratch, hybrid funds provide a way to mitigate some of those challenges.

See “Challenging Fundraising Outlook for PE and VC Offers Unique Opportunities for Private Credit and Emerging Managers” (May 2, 2024).

Also, certain types of investors – e.g., high net worth investors, family offices and some endowments – with more flexibility may be attracted to hybrid funds for the opportunity they offer to include a unique asset class in their portfolio, especially if that can mitigate the J‑curve and provide early distributions, Stoj stated.

Challenges

Although some types of investors are drawn to the flexibility and features afforded by hybrid funds, others find the unique structures less appealing.

Traditional institutional investors tend to have specific buckets for private and public assets, so it can be difficult to identify the appropriate team to approach or get your foot in the door when fundraising for a hybrid fund, Stoj continued. Institutional investors have personnel that deal with evergreen funds and others that work with closed-end funds, and neither will be keen to invest in the other type of structure, Jill agreed. With that said, there appears to be some movement in the institutional asset classes as investors start to see the returns generated by hybrid funds.

Explaining hybrid funds can also be challenging because of their complexity. Investor relations teams and law firms may find it difficult to effectively walk investors through the structural differences and mechanics, Jill added. As PE sponsors move into the evergreen space, there have been more discussions about management fees, carried interest, incentives and how those are all calculated to ensure that everyone understands the product, Niederkofler observed. The desire for maximum flexibility should be a balanced with the need to bring investors in the door, as getting the right mix of features can be a struggle in a fundraise, Stoj stated.

Further, emerging managers need to be particularly thoughtful about how and whether they offer hybrid funds. A person leaving their firm to set up a new sponsor may see a hybrid fund as a way to address issues they had with prior funds, Gindi said. For example, a PE professional that worked with a drawdown structure may be looking for perpetual capital or recycling in the new product. It can be difficult, however, to sell both a new manager and a new bespoke product to investors. Therefore, it is important to consider how a sponsor is going to approach the market and whether LPs will be able to understand and embrace a new product, he emphasized.

See “How Emerging Managers Can Address Key Issues and Challenges” (Sep. 21, 2023).

Performance Advertising

Performance advertising is an issue that arises from time to time with hybrid funds, Gindi noted. Traditional performance calculations such as internal rate of return (IRR) and multiples on invested capital (MOIC) are used in PE, while hedge funds often use annual returns and the like. It may be complicated to use fund-level IRR or MOIC with hybrid funds as those metrics do not account for investors coming in and out of the fund at various times, Jill observed. As a result, there may be more open questions about performance metrics and calculations for hybrid funds than traditional private funds.

One approach is to use fund-level IRR and MOIC on the private side, and to compare IRR to appropriate indexes on the public side, Stoj suggested. That is challenging from a legal and regulatory perspective as it is necessary to tweak the calculation every time it is made to ensure the manager is not improperly selecting certain investments. It is even more complex, she continued, when there are crossover investments (e.g., IPOs).

Showing performance is even more complicated with liquid hybrids that have different classes with different fees, Niederkofler added.

See “Efficiently Navigating Performance Reporting Requirements Under the SEC’s Private Fund Rules, Marketing Rule and FINRA Guidance” (Apr. 18, 2024).

Liquidity and Withdrawals

Liquidity for existing investors is often part of the conversation about how new investors buy into a hybrid fund, particularly when it is more open-ended, Gindi noted. Ares discusses withdrawal mechanisms – which impact the liquidity profile of the fund – with investors during the premarketing process, and investor demand is the main driver for determining which model will be used, Jill emphasized.

Redemption Mechanisms

There are numerous variations of liquidity mechanisms, which can broadly be broken down into four categories, Niederkofler pointed out. It is worth noting, however, there are blended approaches between the different core models set forth below, she said. For example, a client may be considering having one vehicle with liquid and illiquid aspects, and cross-pollinate between the two.

First, the slow pay mechanic may be used by more illiquid hybrid funds and involves creating tranches or series – effectively, operating as side cars – where investors can come in at certain points in time. Withdrawal dates tend to be infrequent (e.g., once or twice a year), but liquidity issues are mitigated by effectively providing investors with their own separately managed account (SMA), Jill added. Investors seem to be questioning slow pay mechanics more often, however, and asking how long it would take for them take their cash out.

Second, open-end hybrid funds commonly provide liquidity on a rolling basis, which involves matching up to a fund that is structured as a series fund or a vintage, Niederkofler observed. That approach is particularly viable if valuations are easily available based on the types of assets held in the fund. After a certain period, investors can elect to roll over into the next series or ramp off, she said. The unfunded portion of a fund that rolls into a new fund can then be supplemented by the manager bringing new subscribers into that fund.

The third category of liquidity mechanisms adds complexity to the slow pay model by including investor- or fund-level gates, Niederkofler continued. That is an important topic among investors looking into hybrid funds because that can decrease their liquidity options. The fourth category is the auction or specified events mechanic, where existing investors are released from a fund if new investors are willing to come in, she concluded.

In addition, more sponsors are applying a core real estate or infrastructure approach, with a redemption queue where investors make a request to pull their cash out that is subject to available cash on hand from new investors or the assets, Gindi noted. If there is no cash available, the investor stays in the queue until the next quarter. There may be a period of time (e.g., a few quarters) within which all investors in the queue are paid out. Similar models have also been seen in non-traded business development companies and non-traded real estate investment trusts.

See “Beyond the Master-Feeder: Managing Liquidity Demands in More Flexible Fund Structures” (May 25, 2017).

Capital Contributions

The assets in a fund tend to drive the admission of investors, Jill said. For example, if there is a deployed portfolio holding liquid assets, then investors can be brought in at the net asset value of the portfolio and contribute all their capital immediately upon joining the fund. That approach is challenging, however, for a portfolio that will be deployed over time and has illiquid assets because sitting on cash will be a drag on IRR, he explained.

To address that, hybrid funds with illiquid assets sometimes admit investors by closing with them in the fund but only issuing capital calls to those investors when there are assets for the cash to be deployed, Jill continued. Effectively, investors are buying into the portfolio as of the date of each drawdown. For example, if the fund is drawing down quarterly, investors’ percentage ownership changes on that date, he elaborated.

That seems to be the most common model, and it may require some complicated discussions with investors, Jill noted. Existing investors may not want the fund to keep growing – such that they are never fully deployed – so the model may include fully deploying the capital of investors that are in the ground first and then moving to the next group, he said.

Asset Mix

To effectively operate a hybrid fund, it is important for sponsors to ensure they have the right mix of assets. Asset composition can provide a measure of protection against liquidity demands – e.g., maintaining a percentage of liquid assets in anticipation of withdrawals – although returns need to be taken into account, Jill suggested.

Attaining the right mix of assets often starts with seeding the vehicle, Gindi asserted. For new products, sponsors may have a seed portfolio and ask anchor investors to contribute assets from an existing SMA or portfolio to help build up the fund for new investors to come in. A good mix of assets and asset liquidity is also important, for example, where there are more concentrated and illiquid assets, vintage and duration diversification of those assets can help generate cash flow on an orderly basis, he explained.

See “Structural and Operational Considerations for Hybrid Funds” (Feb. 23, 2021).

Net asset value (NAV) facilities are secured by the value of a fund’s underlying portfolio and can be structured to cross-collateralize the equity of multiple portfolio companies. The facilities have become an increasingly popular portfolio management tool with PE sponsors, especially when other more traditional sources of liquidity are difficult to access. However, although NAV‑based facilities may be used in a way that ultimately benefits LPs, they may also give rise to conflicts of interest and certain benefits for GPs that come at the expense of LPs. Given the potential pitfalls, the investor community has expressed concerns about GPs’ lack of transparency and engagement with LPs around NAV‑based facilities.

To enhance practices as to the use of NAV‑based facilities, the Institutional Limited Partners Association (ILPA) recently issued guidance (Guidance) with parameters for improving transparency, recommendations for working with existing limited partnership agreements (LPAs) and terms to be included in future LPAs, as well as a disclosure template and specific discussion points for LPs to address with GPs. This article summarizes the key takeaways from the Guidance for PE sponsors.

For coverage of other ILPA guidance, see “ILPA Guidance Promotes Equitable Framework for Continuation Fund Transactions” (Jul. 27, 2023); and “How ILPA’s Model NDA Could Change Preliminary Due Diligence Practices” (Feb. 16, 2021).

LP Concerns Regarding NAV Facilities

Lack of Transparency

It is important that LPs know when a NAV‑based facility is being used - and its terms – so they can fully understand the risks associated with their investments. In practice, however, GPs do not always provide adequate transparency as to their use of NAV‑based facilities. For example, LPs often discover their GP is using a NAV‑based facility when they review distribution notices or other financial reporting, rather than being informed by their GP before the NAV facility is put in place.

The Guidance also notes that the lack of transparency is driven by a lack of industrywide governance on the use of NAV‑based facilities. Typically, NAV‑based facilities are used after the investment period or when most fund commitments have been drawn, so they tend to be governed by older LPAs that do not expressly address them.

GPs have taken various approaches when the LPA is silent on NAV facilities. For example, if the LP advisory committee (LPAC) is authorized to waive borrowing limitations, the GP may obtain LPAC approval to use a NAV‑based facility. GP approval requests are often for the general ability to use a facility during the life of the fund, however, so an LPAC waiver on those terms may support a GP’s attempt to use a NAV‑based facility multiple times.

In addition, many NAV‑based facilities involve a special purpose vehicle (SPV) below the fund, and some GPs view those facilities as being outside the scope of fund-level leverage limits prescribed in the LPA. If NAV‑based facilities are not included in fund-level leverage calculations, LPs have no way of knowing how much leverage a GP can take out above the portfolio company level. As a result, it is difficult for LPs to properly assess the risks associated with their investment.

Liquidity Used for Synthetic Distributions

Early distributions to LPs from borrowings under NAV‑based facilities – known as “synthetic” distributions – materially impact calculations of a fund’s distributed to paid-in capital and internal rates of return because capital is returned earlier than would have been possible without the facility. Using a NAV‑based facility for synthetic distributions can also boost a GP’s headline performance figures, and there is an inference that a GP is taking that approach to attract commitments to its next fund. In addition, the impact of NAV facilities on funds’ performance calculations can make it difficult for LPs to compare different GPs’ performance figures because GP disclosures about using NAV facilities can vary substantially.

Further, synthetic distributions from NAV‑based facilities come with costs to LPs. Interest is payable to the lender and is often charged as a partnership expense. Distributions from NAV‑based facilities are also often recallable, which disrupts LPs’ cash flow planning and prevents them from allocating that capital to other funds or distributing it to their beneficiaries. Recallable distributions can create tax issues, as well as difficulties around accounting treatment for certain LPs. In addition, media attention around NAV‑based facilities has prompted more questions from LPs’ stakeholders, which can be challenging for LPs to answer when they have limited insight into the overall use of such facilities in their portfolios.

See “LP Concerns and Common Misconceptions About the Rise of ‘Synthetic’ Distributions (Part One of Two)” (Jul. 11, 2024).

Supporting the Portfolio

The Guidance notes that funds should have sufficient capital reserves to support portfolio companies after the investment period and in challenging markets, as well as to fund potential follow-on or opportunistic investments. Accordingly, if a NAV‑based facility is needed for those purposes and a GP does not engage with LPs about the rationale, the inference is that the GP has overcommitted the fund or mismanaged its reserve capital.

The primary concern raised by LPs is that NAV‑based facilities come with cross-collateralization risk, especially if some of the proceeds are used to support a struggling portfolio company that may ultimately fail. Importantly, a large facility secured by a blended group of assets with varying upside potential may compromise a key factor in alpha generation for a PE strategy.

LPs are also concerned about GPs using NAV‑based facilities to support their most recent fund when they are struggling to fundraise, especially after all capital has been called. For example, a GP could use a NAV‑based facility to increase its assets under management and, as a result, any management fees calculated on cost. The facility may also enable a GP to achieve carry and prove their viability. ILPA noted that those situations present the greatest potential misalignment of GP‑LP interests when it comes to using NAV‑based facilities.

ILPA Recommendations

Improving Transparency and Engagement

Unless explicitly permitted by a fund’s LPA or the GP has received prior approval, GPs should seek LPAC consent before implementing a NAV‑based facility. When engaging with a fund’s LPAC, a GP’s disclosures about its prospective use of a NAV‑based facility should include information about:

• the rationale and use of proceeds, including details of any alternatives the GP considered;
• the anticipated NAV facility size, structure and controls, which should include a discussion of:
  • amounts to be drawn at closing;
  • any undrawn amounts available to be borrowed in the future;
  • any use of SPVs, subordination provisions and/or cross-collateralizations;
  • pertinent repayment requirements and key covenants; and
  • whether the facility will be secured or unsecured;
• key economic terms, to the extent permitted under the lender’s restrictions; and
• LP obligations, including whether any distributions received are recallable.

See “A Comparison Between Two Liquidity Solution Tools: Preferred Equity and NAV Facilities” (Oct. 13, 2020).

Regardless of whether the LPA explicitly addresses NAV‑based facilities, the Guidance recommends that:

• Any conflicts of interest associated with the facility should be brought to the LPAC.
• GPs should seek LPAC approval if they intend to use any of the facility proceeds to provide a synthetic distribution, including an explanation of the rationale and how the facility will maximize LP returns while not incurring risks that exceed LPs’ expectations.
• When the GP has received prior consent to use a facility, the GP should not be required to return to the LPAC for consent to use it to support the portfolio, and the facility should be treated like more traditional leverage. The GP should still disclose to all LPs, however, that it is implementing a NAV facility to support the portfolio and provide its rationale.

Governance

Existing LPAs

When existing LPAs are silent on NAV‑based facilities, the Guidance recommends that LPs review the LPA’s fund borrowing and fund-level leverage provisions. In particular, the limitation of indebtedness provisions should prescribe the type of borrowing the fund is permitted to incur.

It is not uncommon for LPAs to expressly allow a manager to take out a subscription line of credit but not consider a NAV‑based facility with the fund or an SPV as borrower. In those circumstances, LPs should clarify whether their GP interprets those provisions as authorization to use a NAV‑based facility.

See our two-part series on ILPA’s subscription credit facilities guidance: “Reiterating the Need for Increased Disclosures on the Use of Facilities and LP Obligations” (Aug. 25, 2020); and “Sponsor Skepticism Over the Value and Potential Harms of Excessive Disclosures to LPs About Facilities” (Sep. 1, 2020).

The Guidance also recommends that LPs proactively discuss NAV‑based facilities with their GPs to understand whether the fund documents have been interpreted to exclude facilities taken out by an SPV or master holding company from fund-level leverage provisions.

Future LPAs

New LPAs should expressly address NAV‑based facilities to ensure the GP and LPs have a common set of expectations and to put appropriate safeguards in place. The Guidance recommends that new LPA language should:

• set out reporting expectations around NAV‑based facilities;
• define limits for the amount of leverage the GP can incur through NAV‑based facilities throughout the fund’s life; and
• define the term “NAV‑based facility” so any SPV that is used will count toward the calculation of the leverage limit, but avoid capturing SPVs or borrowing structures set up to support other forms of debt (i.e., single company portfolio debt).

ILPA did not recommend a specific percentage threshold to limit the amount of NAV‑based facility exposure, which should be negotiated between LPs and GPs based on the fund’s strategy and relevant risk factors.

New LPA terms should also outline the LPAC’s role and responsibilities regarding NAV‑based facilities, including that the GP is required to obtain LPAC and/or broader LP approval for all conflicts of interest associated with a NAV‑based facility. Similarly, the Guidance recommends that GPs seek LPAC and/or LP approval for any conflicts of interest that may arise from the transaction, irrespective of whether the LPA specifically addresses NAV‑based facilities.

Further, ILPA cautions LPs against:

• LPA provisions that give GPs broad authority to implement NAV‑based facilities with little LPAC/LP oversight; and
• language that preclears conflicts associated with NAV‑based facilities or that could be interpreted as doing so.

See “Communication Tactics, LPA Provisions and Fund Structures to Allay LPs’ Anxiety About ‘Synthetic’ Distributions (Part Two of Two)” (Jul. 25, 2024).

ILPA Templates

Standardized Disclosure

The Guidance recommends that GPs provide all LPs with standard disclosures regarding NAV‑based facilities once they are in place, and provides the following template that covers the rationale, key terms and conflicts:

1. What is the rationale for using a facility, versus alternative options? Will it be used to repay existing indebtedness, for follow-on investments, to support the portfolio, for a distribution to LPs, etc.? Why is extra capital needed now?
2. What is the overall size of the facility?
3. What is the amount borrowed from the facility to date?
4. What is the initial loan-to-value (LTV) ratio at the initial date of borrowing?
5. Please describe the interest rate of the facility. Is the interest rate fixed or floating? If floating, please provide the base rate (e.g., secured overnight financing rate) and the spread in basis points. Is the interest required to be paid in cash, or can it be paid-in-kind?
6. What is the tenor/term end date of the facility, including any extensions, if applicable? How is the facility meant to be repaid?
7. Please describe the structure of the facility, including the use of SPVs or subsidiaries.
8. Please describe any security interests provided as collateral, including any pledge of uncalled capital and any interests in the underlying portfolio companies, SPVs or subsidiaries.
9. Describe the details of the financial covenants as well as other core items, including:
   1. cash sweeps and mandatory repayments;
   2. the interest rate coverage ratio;
   3. the security coverage ratio;
   4. the LTV ratio; and
   5. remaining portfolio company diversification.
10. Please describe if a credit rating has been obtained through a nationally recognized statistical rating organization.
11. Please describe any potential conflicts of interest associated with the facility lender (e.g., is the lender a related entity?).
12. Please describe any consents that are required and confirm that all required consents or waivers have been obtained.

See our two-part series: “Nuances and Trends in Negotiating Loan‑to‑Value Ratios in NAV Facilities” (Apr. 26, 2022); and “Covenants, Diligence and Collateral Considerations of NAV Facilities for Private Funds” (May 10, 2022).

Discussion Items

The Guidance also includes a template with the following questions to guide LPs in their dialogue with GPs when a NAV‑based facility is proposed or put in place:

1. Is the amount of leverage resulting from the NAV facility appropriate given the rationale, existing asset-level leverage and other factors (e.g., diversification/concentration in the fund’s portfolio)? Has the GP appropriately considered the increased risk when putting the NAV facility in place?
2. Will proceeds be used in a way that is consistent with the best interests of the fund and the LPs? Has the GP reasonably demonstrated the impact of the NAV facility on returns to LPs in the fund?
3. If the facility is used for a synthetic distribution, how will that impact the waterfall? Does the facility trigger a payment of carried interest, and is there any risk of a GP clawback arising from the distribution?
4. If the facility is used to generate a synthetic distribution, will the management fee be reduced to reflect the distributed amounts?
5. How will the NAV facility impact uncalled commitments? If the facility is used to generate a synthetic distribution, will the distribution be recallable? Is there a pledge of uncalled commitments?
6. Is the leverage resulting from the NAV facility included as “fund leverage” in the measure of fund-level leverage as defined in the LPA (e.g., within borrowing provisions)?
7. Do any LPs have side letter or exclusion rights that may lessen their exposure to the facility?
8. Will details about the facility be disclosed in the fund’s audited financial statements, even if an SPV or other vehicle that sits below the fund has been used for the facility?
9. Who at the GP is responsible for monitoring the usage and performance of the facility, including monitoring LTV ratios and other covenants?

In addition, ILPA recommends that LPs consider qualitative factors beyond the contractual terms of the NAV facility and asses the following items to understand the impacts and potential risks:

• the GP’s recent track record and current circumstances (e.g., health of the portfolio, sectoral challenges, status of current fundraise);
• the age of the fund and its performance relative to the hurdle rate (i.e., is the fund near the end of its life but the GP is below the hurdle rate?);
• the GP’s historical management of debt and leverage at the fund and portfolio company level; and
• the GP’s valuation processes and its finance function’s oversight of compliance with facility covenants.

See “The State of NAV Loan Facilities in the PE Industry and Current Obstacles to Widespread Adoption” (Feb. 9, 2023).

The SEC recently issued its spring 2024 so-called “Reg Flex” agenda. The SEC’s spring 2024 regulatory agenda has 34 items, including 15 at the proposed rule stage and 19 at the final rule stage. Those in the final rule stage that are most relevant to private fund advisers are slated to be finalized by the end of October 2024.

The items in the agenda most immediately relevant to private fund advisers are the planned final rules for outsourcing; disclosure on environmental, social and governance (ESG) practices; and cybersecurity risk management and reporting, Christopher S. Avellaneda, partner at Schulte Roth & Zabel, told the Private Equity Law Report. Potential reproposals of the Safeguarding Rule and the Predictive Data Analytics (PDA) Rule could also be highly relevant to private fund managers.

This article discusses the agenda items of relevance to private fund managers, with additional commentary from Avellaneda.

See “SEC’s Fall 2022 Reg Flex Agendas Offer No Relief From Relentless Rulemaking” (Feb. 23, 2023).

Rules to Be Finalized

ESG Disclosure

In May 2022, the SEC proposed rules requiring enhanced disclosure on ESG practices by registered investment advisers, certain exempt advisers, registered investment companies and business development companies. Covered advisers would be required to disclose on Form ADV whether they consider any ESG factors, or follow any ESG frameworks, in the investment process and provide associated narrative disclosures. The purpose of the rule is to “create a consistent, comparable, and decision-useful regulatory framework for ESG advisory services and investment companies to inform and protect investors while facilitating further innovation in this evolving area of the asset management industry,” noted the SEC.

See “Recent SEC ESG Rulemaking, Examination and Enforcement Activity” (Aug. 10, 2023); and our two-part series on the SEC’s proposed ESG rules: “Nuanced Concerns About Three ESG Categories and Other Form ADV Requirements” (Aug. 23, 2022); and “Forecasting the Private Fund Industry’s Response and Offering Compliance Tips” (Aug. 30, 2022).

Cyber Risk Management and Incident Reporting

Announced in February 2022, the proposed cyber risk management rules for investment advisers and investment companies would require advisers to:

• adopt and implement policies and procedures reasonably designed to address cybersecurity risks;
• report significant cyber incidents;
• provide enhanced disclosure on cyber risks and incidents; and
• enhance recordkeeping requirements.

A separate rule would impose similar requirements on broker-dealers, exchanges and other market participants.

See “A Practical Approach to Navigating the New Cybersecurity Legal and Regulatory Landscape” (Aug 24, 2023).

Outsourcing

This proposed rule would prohibit advisers from outsourcing certain functions without conducting due diligence, periodic monitoring and related recordkeeping.

See our two-part series: “SEC Proposes New Diligence, Monitoring and Recordkeeping Standards for Overseeing Service Providers” (Dec. 1, 2022); and “Concerns, Criticisms and Critiques of the Practical Impact of the SEC’s Proposed Rules for Overseeing Service Providers” (Dec. 15, 2022).

Best Execution

The proposed rule on Proposed Regulation Best Execution would:

• establish a best execution standard for broker-dealers;
• require them to have detailed policies and procedures to ensure compliance;
• require additional policies concerning conflicted transactions with retail customers; and
• mandate enhanced best execution review and recordkeeping.

Swaps Reporting

The proposed security-based swaps position reporting rules under Section 10B of the Securities Exchange Act of 1934 (Exchange Act) would require public disclosure of information regarding certain large positions in security-based swaps.

Broker‑Dealer Customer Protection

The SEC’s July 2023 proposal would amend the broker-dealer customer protection rule to require daily, rather than weekly, calculation of reserve amounts and associated deposits.

Shareholder Proposals

The SEC has proposed amending the substantial implementation, duplication and resubmission exclusions for shareholder proposals subject to Rule 14a‑8 under the Exchange Act.

Rule Proposals

Custody

In February 2023, the SEC proposed a new Safeguarding Rule – Rule 223‑1 under the Investment Advisers Act of 1940 (Advisers Act) – to replace the Custody Rule. The SEC expects to repropose the Safeguarding Rule by the end of October 2024.

See our two-part series on the proposed Safeguarding Rule: “Parameters and Requirements of the Long Overdue Update to the Custody Rule” (Mar. 23, 2023); and “Concerns About the Scope and Specific Items for Closed‑End Fund Managers to Monitor” (Apr. 6, 2023).

Predictive Data Analytics

In July 2023, the agency proposed rules related to broker-dealer and investment adviser conflicts associated with using PDA, artificial intelligence, machine learning and similar technologies (PDA Rules). The Commission anticipates reproposing the PDA Rules by the end of October 2024.

See “Preparing for the SEC’s Proposed Predictive Data Analytics Rules and Mitigating Generative AI Risks” (May 16, 2024); and “SEC’s Proposed Conflicts Rules for AI Erode Primacy of Disclosure and Investor Consent Principles” (Sep. 7, 2023).

Incentive‑Based Compensation

The SEC is considering reproposing regulations and guidelines pursuant to the Dodd-Frank Act with respect to incentive-based compensation practices at certain financial institutions with more than $1 billion in total assets. The Dodd-Frank Act called for the SEC and other agencies to prohibit incentive-based compensation arrangements deemed to encourage inappropriate risk-taking. These reproposals were also slated for October 2024.

See our two-part series on tax developments and fund manager compensation: “Management Fee Waivers” (Aug. 24, 2021); and “Carried Interest Waivers and In‑Kind Distributions” (Aug. 31, 2021).

Customer Identification Programs

By separate rulemaking, certain investment advisers may be deemed “financial institutions” under the Bank Secrecy Act. If that occurs, the SEC and Treasury have jointly proposed regulations requiring such advisers to implement reasonable customer identification procedures. The comment period for such regulations expired on July 22, 2024.

See “FinCEN and SEC Issue Proposed Customer Identification Program Requirements for Investment Advisers” (Jun. 27, 2024).

Regulation D and Form D

The SEC may amend Regulation D, including the definition of “accredited investor,” and Form D “to improve protections for investors,” according to the SEC agenda. Advisers should be on the alert for these proposed updates, noted Avellaneda. Many private fund managers rely on the exemption from registration in Section 3(c)(7) of the Investment Company Act of 1940. Such advisers are less affected by changes to the accredited investor definition. However, “changes to disclosure requirements on Form D could still be impactful, and many firms still use the [Section 3(c)(1) exemption] for certain funds,” he said.

See “SEC Commissioner Crenshaw Speech Forbodes Potential Reg D Reforms to Tailor the Safe Harbor” (Feb. 23, 2023).

Updated “Held of Record” Definition

A proposed rule to update the definition of securities “held of record” under Section 12(g) of the Exchange Act could be significant, noted Avellaneda. Such a rule, which has been a topic of discussion for some time, “could impact funds with a larger number of investors or large share classes.”

Other Possible Rule Proposals

Other rule proposals that may, directly or indirectly, affect private fund managers include:

• potential reproposal of amendments to the Rule 144 safe harbor for public sales of restricted or control securities;
• a joint rulemaking among the SEC and other federal agencies on data standards for information reported by financial entities under the agencies’ respective jurisdictions;
• public company reporting, including:
  • proposing regulations requiring enhanced disclosure by public companies about the diversity of board members and nominees; and
  • rule amendments to enhance registrant disclosures regarding human capital management;
• reproposal of amendments regarding liquidity and dilution management for open-end funds;
• amendments to requirements for registered investment company fees and fee disclosures; and
• amendments to modernize Regulation ATS, including requirements to promote pre-trade price transparency across asset classes.

Impact of Loper Bright and National Association of Private Fund Managers

The recent Supreme Court decision in Loper Bright Enterprises v. Raimondo holds that courts are not required to defer to agencies’ interpretations of silent or ambiguous statutes. The decision of the U.S. Court of Appeals for the Fifth Circuit in National Association of Private Fund Managers v. SEC vacated the SEC’s private fund adviser rules. Those rulings have created significant uncertainty over agency rulemaking.

Although uncommon, there have been occasional rule reproposals following similar decisions, noted Avellaneda. Reproposals of the PDA, Incentive-Based Compensation and Safeguarding Rules “are likely to address the points raised by commenters in the initial notice and comment process,” he said. Additionally, “it seems likely that the SEC will seek to get ahead of the issues raised by [National Association of Private Fund Managers and Loper Bright], which could be relevant to whether a final rule would ultimately be susceptible to challenge.”

See “What Jarkesy and Other Recent Landmark U.S. Supreme Court Rulings Mean for the Private Funds Industry” (Aug. 22, 2024).

“The SEC is likely to adapt to the possibility of being challenged and will need to consider the likelihood of an administrative law challenge to future rulemakings,” continued Avellaneda. “It’s not easy to predict what the approach would be going forward,” he conceded, “but it could result in:

• narrower proposed and adopted rules;
• more detailed, concrete support for the basis of rulemaking;
• a slower pace of rulemaking; and
• increased reliance on existing rules, staff guidance and enforcement activity as a way to apply existing rules in a manner that furthers the SEC’s priorities.”

In light of the recent decisions, it may become easier to challenge rules. However, “the willingness of individual firms in enforcement proceedings to litigate cases will be highly fact-specific,” observed Avellaneda.

See “Fallout From the Fifth Circuit’s Bombshell Ruling Vacating the Private Fund Adviser Rules” (Jun. 27, 2024).

Paul Weiss has announced that investment funds lawyer David Pritchett will join the firm as a partner in its London office. His practice focuses on advising fund managers on all aspects of structuring and operating alternative investment funds across a variety of investment strategies and asset classes.

For insights from Paul Weiss, see “Recent Survey Shows Market Adversity Is Tempering LPs’ Ability to Negotiate Key PE Fund Terms” (Sep. 5, 2024).

Pritchett advises on an array of transactions that are unique to PE, including co‑investments, secondary transactions and fund spin‑outs. He also has experience assisting managers with related carried interest, co-investment and other incentive arrangements.

See our two-part series on tax developments and fund manager compensation: “Management Fee Waivers” (Aug. 24, 2021); and “Carried Interest Waivers and In‑Kind Distributions” (Aug. 31, 2021).

Pritchett arrives from Kirkland & Ellis, where he was as a partner in the international funds group.