2020 in the Rear-View Mirror:  Key Takeaways Applicable to Private Investment Funds and Private Offerings

In 2020, the Securities and Exchange Commission (SEC) renewed its focus on private investment funds while easing limits on private placements generally.  As the SEC observes, private fundraising easily surpasses public fundraising including with respect to private investment funds.  The following discussion recaps a few of the key developments affecting private offerings, private funds and investment advisers from 2020 including ESG factors to consider whilst preparing for new transactions and offerings in 2021.

Private Offering Changes.  SEC amendments in 2020 affecting private offerings and private funds alike include to:

• raise the offering maximum for Tier 2 offerings under Regulation A to $75 million;
• raise the offering maximum for crowdfunding transactions from $1.07 million to $5 million;
• create four non-exclusive safe harbors from a potential integration of securities offerings to facilitate multiple private placements by the same issuer;
• raise the maximum offering amount permitted from $5 million to $10 million under Rule 504 of Regulation D;
• permit the “testing of the waters” in connection with certain exempt offerings before they decide on an exemption to use for the sale of the securities;
• permitting Regulation Crowdfunding issuers to “test the waters” before submitting offering documents to the SEC, consistent with Regulation A requirements; and
• provide for an additional method of verifying a potential purchaser’s status as an accredited investor under Rule 506(c) of the Securities Act.

The final rule becomes effective on March 15, 2021, with certain exceptions.

Amendments to the Accredited Investor Definition.  As previously reported[2] in the Rimon Law Investment Management Blog, the SEC voted on August 26, 2020 to expand the definition of “accredited investor” to allow a natural person to become an accredited investor based on financial sophistication, rather than only based on income or net worth.

The SEC added a new category to the definition to allow natural persons to qualify as accredited investors based on specific professional credentials and “knowledgeable employees” of private funds.  The SEC expanded the list of entities that qualify as an “accredited investor” to include, among others, investment advisers registered under the Investment Advisers Act of 1940 and advisers registered under state law, as well as exempt reporting advisers.  Moreover, the SEC’s changes include an expanded list of entities that qualify as a “qualified institutional buyer” to include, among others, limited liability companies and rural business investment companies.

Private fund managers and other issuers that conduct private offerings are advised to update subscription agreements, offering documents, and other documents, policies and procedures to reflect the changes to the definitions.

ESG Developments.  As part of the EU’s strategy on climate change following the Paris Agreement of 2015, a number of EU regulations have been enacted in the past 12 months.  The two most important applicable to private funds include the “Sustainable Finance Disclosure Regulation” and the “Taxonomy Regulation.”

The Taxonomy Regulation creates a classification system in relation to environmental objectives to provide more information and greater transparency to investors in relation to sustainable investments. One aim is to counter “greenwashing” where fund products are marketed with environmental aims, that do not deliver on the promises. Although enacted earlier this year, the main provisions of the Taxonomy Regulation will come into force in two stages (i) in January 2022 following the publication of “technical screening criteria” in relation to two of the environmental objectives (climate change mitigation and climate change adaptation), and (ii) in January 2023.

The Sustainable Finance Disclosure Regulation (SFD Regulation) takes effect on March 10, 2021. The SFD Regulation sets out the framework of the obligations that will come into clearer view through regulatory technical standards (RTS), but their introduction has been delayed and they will not be ready for the start date.  Compliance with the “high level principles” of the regulation is expected from March 10, 2021, and following the finalization of the RTS, more detailed compliance can then follow (expected to be from January 2022).

The immediate task for those entities within scope, so called “Financial Market Participants,” which includes alternative investment fund managers (AIFMs), portfolio managers among others, and “Financial Advisers” which covers investment advisers, is to determine how to comply with the Disclosure Regulation from March 10, 2021. From this date, in-scope funds and entities will need to comply regardless of whether their funds have an ESG focus or sustainable investment objectives. There are additional obligations in relation to these types of funds but there is a baseline of compliance required by all.

All EU based entities will be in scope, as well as non-EU entities marketing fund products to EU investors. While the UK may not be subject to EU law from starting this month in January 2021, if UK managers are intending to market under into the EU they will fall within the scope of the Regulation.  The disclosure obligations can be split broadly into website disclosures and pre-contractual disclosures.

Firms are required to make certain disclosures on their websites and to clients and investors on a pre-contractual and periodic basis about financial products (e.g., funds).  Information to be disclosed on websites include disclosure of the integration of sustainability risks in the investment decision making process or investment advice, whether the manager considers the principal adverse impacts of investment decisions on sustainability factors (and if so, a statement on their due diligence policies with respect to those impacts, and if not, clear reasons for why they do not do so), and information on how its remuneration policies are consistent with the integration of sustainability risks.

AIFM portfolio managers and investment advisers must include similar disclosures in the delegation/advisory agreements.  The disclosures will include (i) the manner in which sustainability risks are integrated into investment decisions/advice, (ii) the results of the assessment of the likely impacts of sustainability risks on the returns of the financial products, and (iii) where principal adverse impacts of investment decisions on sustainability factors are not considered, a clear statement that it does not consider the adverse impacts of investment decisions on sustainability factors and the reasons why.

While much of the disclosures are relatively straightforward, the consideration of the principal adverse impacts is the main area of concern for fund managers.  Draft RTS designed to provide the detail on these disclosures were published earlier this year as part of the EU’s consultation and could have been incredibly onerous and difficult to comply with.  However, the introduction of the RTS has been delayed and hopefully the EU will revisit their approach to make detailed compliance more straightforward.  This still leaves a large degree of uncertainty, so we would expect that whilst some fund managers will seek to get to grips with this disclosure obligation despite the uncertainty, others may seek to explain why they choose not to comply with the principal adverse impact obligations from March 10, 2021 onwards until publication of the RTS. However, this “comply or explain” option is not available for managers who are part of groups that have more than 500 employees, as they are obligated to comply from June 30, 2021.

Many fund managers emphasize ESG factors and could be said to be promoting these characteristics. The result may be that fund managers are actually discouraged from adopting or expanding ESG policies and best practices, given that doing so may result in an increased burden regarding disclosures and reporting. Coupled with the recent Department of Labor Regulation that may well discourage fund managers targeting ERISA money from promoting ESG practices or policies, the result is a possible retrenchment by fund managers at a time when good ESG practices should be encouraged.

All funds to which the rules apply now should now be looking towards March 10, 2021 and ensuring that the required website disclosures are made by that date, and any funds actively being marketed beyond that date must have the necessary pre-contractual disclosures included.  Later in 2021, there will be further work required to ensure compliance with the detailed technical standards, and from January 2022 onward the first part of the Taxonomy Regulation will be in play.

The OCIE Risk Alert.  On June 23, 2020, the SEC’s Office of Compliance Inspections and Examinations (OCIE) issued “Observations from Examinations of Investment Advisers Managing Private Funds.”[1]  This risk alert identified three deficiencies highlighted by OCIE with regards to investment advisers: (1) conflicts of interest; (2) fees and expenses; and (3) the use of material, non-public information.

The OCIE staff observed that private fund advisers often have interests in investments recommended to clients, but do not provide adequate disclosure of such conflicts. In some instances, adviser principals and employees had undisclosed preexisting ownership interests or other financial interests, such as referral fees or stock options in the investments.   The OCIE staff further observed private fund advisers that allocate limited investment opportunities to new clients, higher fee-paying clients, or proprietary accounts or proprietary-controlled clients on a preferential basis.  Such regime deprives certain investors of limited investment opportunities without adequate disclosure.  The staff observed private fund advisers that allocated securities at different prices or in apparently inequitable amounts among clients without providing adequate disclosure about the allocation process or in a manner inconsistent with the allocation process disclosed to investors, thereby causing certain investors to pay more for investments or not to receive their equitable allocation of such investments.

With regards to side letters, the OCIE staff observed private fund advisers that entered into agreements with select investors (“side letters”) that established special terms, including preferential liquidity terms, but did not provide adequate disclosure about these side letters.  As a result, some investors were unaware of the potential harm that could be caused if the selected investors exercised the special terms granted by the side letters. Similarly, the staff observed private fund advisers that set up undisclosed side-by-side vehicles (i.e., sidecar funds) that invested alongside the flagship fund, but had preferential liquidity terms.  Failure to disclose these special terms adequately meant that some investors were unaware of the potential harm that could be caused by selected investors redeeming their investments ahead of other investors, particularly in times of market dislocation where there is a greater likelihood of a financial impact.

In connection with co-investment, the OCIE staff observed inadequate disclosure of conflicts associated with investments by co-investment vehicles thus potentially misleading investors as to how these co-investments operate.  For example, private fund advisers did disclose a process for allocating co-investment opportunities among select investors or co-investment vehicles and funds but failed to follow the disclosed process.  The OCIE staff also observed private fund advisers having agreements with certain investors to provide co-investment opportunities to those investors but did not provide adequate disclosure about the arrangements to other investors. This lack of adequate disclosure may have caused investors to not understand the scale of co-investments and in what manner co-investment opportunities would be allocated among investors.

The appearance of conflicts of interest, fees and expenses, and policies and procedures in the OCIE Risk Alert suggests that, at least in the SEC staff’s view, a significant percentage of private fund advisers continue to have room for improvement with respect to these perennial issues.  Indeed, certain of the issues highlighted in the Risk Alert have been the subject of very recent SEC enforcement actions against private fund advisers.

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Further developments affecting ESG regulation and private funds generally will be monitored by Rimon Law and posted here.

[1] https://www.sec.gov/ocie/announcement/risk-alert-private-funds
[2] See SEC adopts amendments to the “accredited investor” definition – The Rimon IM Report (rimonlaw.com) and SEC Expands Pool of Eligible Private Offering Participants – The Rimon IM Report (rimonlaw.com).