In a ruling with potential far-reaching consequences for the burgeoning private credit market, a U.S. appeals court has delivered a significant blow to the Securities and Exchange Commission’s (SEC) efforts to enhance transparency and oversight in the 27.000 billion dollar private funds industry. The private fund industry can breathe a sigh of relief, for now.
The New Orleans-based 5th U.S. Circuit Court of Appeals last week nullified a set of SEC rules introduced in August 2023. These rules aimed to enhance transparency of private equity funds and hedge funds.
Transparency rules overturned
The now-invalidated rules required private fund managers to provide detailed quarterly reports on performance, fees, and expenses, undergo annual audits, and eliminate preferential treatment for certain investors through side letters and other arrangements.
In a unanimous decision, the three-judge panel ruled that the SEC had overstepped its statutory authority in adopting the rules, siding with six industry groups that had contested the regulations.
This ruling marks a victory for the private funds industry, which argued that the SEC›s push for transparency threatened to fundamentally alter business practices and impose undue compliance costs estimated at nearly 500 million dollars annually.
The Fifth Circuit’s decision to vacate the entire rule came as a surprise to many. Certain aspects of the rule, such as those concerning preferential treatment, were on shakier ground due to the SEC’s reliance on statutory authority that seemed intended for retail investors.
According to Karl Paulson-Egbert, global co-chair of the investment funds group and adjunct professor of Law at Georgetown University, that is now irrelevant: «The rule as a whole is overturned. The SEC will make noises about exploring its legal options, but I wouldn’t be shocked to see portions of the rule re-proposed and based on more sturdy statutory authority,» he wrote on LinkedIn.
It is uncertain which implications this ruling might have in Europe, where both Esma and national authorities have increasingly sought to standardise their approach on various issues for both Ucits and AIFs under AIFMD.
Investor protection concerns
The decision has drawn sharp criticism from investor advocates and financial reform groups, who argue that the now-nullified rules were essential for protecting ordinary investors with indirect exposure to private funds through pension and retirement plans.
The appeals court’s decision comes at a particularly precarious time for the private credit market, which has seen meteoric growth in recent years but is now showing signs of potential liquidity strains.
Recently, asset manager Blackstone blocked investor exits from a 69 billion dollar real estate fund, while Canadian firm Ninepoint suspended redemptions from three investment funds citing liquidity concerns - events drawing parallels to the 2007 subprime mortgage crisis.
«This is a terrible setback on many levels,» said a former New York-based private equity professional in conversation with Investment Officer. «There is no easy way to find out if funds are in trouble because these funds› performance is extremely well guarded. Even many of the limited partners (LPs) can’t get full details of portfolio performance,” he said, wishing to remain anonymous.
Against this backdrop, the ruling vacating the SEC›s disclosure rules has raised fears that the private credit market could face even less regulatory scrutiny at a pivotal juncture, potentially encouraging further risky behaviour and exacerbating systemic risks.
As the SEC considers its next steps, the ruling has reignited debates over the agency’s power to impose guardrails and ensure adequate investor protections as the private credit boom unfolds, with critics warning it could prove to be the proverbial «canary in the coal mine.»
«In my view, pension and insurance companies should have access to the financial information but also professionals qualified to actually manage the risks. Often there is a skill asymmetry between the buy and the sell side of those funds, and it’s not easy to ask the right questions,” the source said.
«Unless they have some undue influence in the management company itself, they don’t get access to underlying assets› financials or operating information. That information is filtered before it goes into quarterly reports.”