The US regulatory scene for private capital and related funds remains very active. For example, on 11 September 2023, the SEC announced charges against nine registered investment advisers for advertising hypothetical performance to the general public in violation of the Marketing Rule and penalties totalling $850,000.

The Marketing Rule, an amendment to the Investment Advisers Act which came into force on 4 May 2022 (although firms had until 4 November 2022 to comply) brought together and modernised the rules that govern investment adviser advertisements and marketing communications. Amongst other things, the Marketing Rule prohibits investment advisers from including hypothetical performance in any advertisement unless the adviser:

• adopts and implements policies and procedures reasonably designed to ensure that the hypothetical performance is relevant to the likely financial situation and investment objectives of the intended audience of the advertisement;
• provides sufficient information to enable the intended audience to understand the criteria used and assumptions made in calculating such hypothetical performance; and
• provides sufficient information to enable the intended audience to understand the risks and limitations of using such hypothetical performance in making investment decisions.

The SEC found that the nine firms had failed to satisfy limb 1. Two firms were also found not to have maintained records of their advertisements, as required by the Marketing Rule.

All nine firms agreed to settle with the SEC, and pay civil penalties ranging from $50,000 to $175,000. The firms agreed to be censured, cease the activity which violated the Marketing Rule and gave undertakings not to advertise hypothetical performance without having the necessary policies and procedures in place.

The SEC’s investigation of potential Marketing Rule violations is ongoing.

We draw clients’ attention to the changes in U.S. ECI withholding tax rules that came into force on 1 January 2023, which are now impacting a large number of managers who handle transfers (and investors who either buy or sell partnership interests). ECI or “Effectively Connected Income” is income that arises from a US trade or business and which is taxable in the hands of foreign recipients.

In order to protect their ability to collect tax from non-US persons, the US imposes a 10% withholding liability on any purchaser (or transferee) of a partnership interest. While this is aimed at partnerships which might have a trade or business in the US (and so some ECI) the rules technically apply to any transfer of a partnership anywhere in the world.

While these rules have been around since 2017, until recently many market participants were happy to “take a view” on the jurisdictional reach of the US withholding rules where there is clearly no US or ECI exposure in the fund.

However, on 1 Jan 2023 U.S. “backstop withholding” kicked in. Under this rule, if a transferee fails to properly withhold on the transfer of a partnership interest, the partnership itself is required to withhold an amount equal to the under withheld amount (plus interest) from future distributions that would otherwise be payable to such transferee. This puts the liability squarely on GPs if the requirements of withholding are not complied with and so many GPs are taking much closer interest in the compliance of transferees in secondary transactions.

To ensure compliance, the seller of an LP interest may be able to give a certificate in some limited circumstances, but in many cases the only way to ensure compliance is for the manager itself to give a certificate as to the extent of its US exposure. Transferees are also now required to certify to the underlying partnership the extent to which it satisfied its obligation to withhold no later than 10 days after the transfer (a Transferee Certification).

Further to the overview in September’s private funds radar, we have produced in response to client requests to “cut through the issues” this three minute guide to the SEC’s new Private Fund Adviser Rules which are expected to come into force before the end of 2023 (subject to transitional arrangements).

We hope this proves to be an efficient and informative summary.

There remains a continued focus on AML and “greenwashing” in the US.

On 25 September 2023, the SEC issued two enforcement actions to DWS Investment Management Americas Inc. (DWS), a subsidiary of Deutsche Bank AG. DWS agreed to pay $25m in penalties to settle both charges.

In the first action, the SEC found that DWS-advised mutual funds had failed to develop and implement appropriate anti-money laundering policies. The SEC found that the AML policies adopted, which were designed for the US operations of Deutsche Bank, did not address the specific requirements for the mutual funds themselves. Although DWS had purchased software designed to generate alerts where suspicious activity was indicated, the firm’s obligations to put in place reasonable AML policies and procedures were not satisfied as DWS had not specified how they would determine the scenarios which the software would monitor.

In the second action, which accounts for $19m of the total penalties, the SEC found that DWS misled investors by overstating the degree to which ESG considerations were integrated into certain actively managed funds and SMAs. The SEC found that DWS did not, as it claimed, consistently integrate relevant ESG aspects into their valuation models. Furthermore the SEC found that DWS published their ESG integration policy on their marketing website at a time when they knew or ought to have known – because internal analysis had so indicated – that the policy was not being consistently implemented by analysts.

On 27 September 2023, the Financial Times reported that the FCA will begin a review during 2023 of disciplines and governance over valuations in private markets. The review is expected to encompass those responsible for valuations within a firm, how valuation information is disseminated to management and other governance procedures in place.

Regulators around the world are increasing their scrutiny into private markets and private funds. For example, the US SEC has introduced new disclosure rules for private fund advisers and the global Financial Stability Board has launched an investigation into leverage in hedge funds. These initiatives form part of a broader regulatory concern with the growth of so-called “shadow banking” following the introduction of tighter regulations on the banking sector since 2008.

The FCA’s review is driven by several factors. Private markets have grown substantially in recent years, particularly as the rate of companies deciding to IPO has slowed. In addition, private markets more closely mirror retail markets as retail investors have sought higher returns in a chronically low interest rate environment (a process referred to as retailisation). Now that interest rates have risen and look set to remain higher for longer, with the potential for increased market volatility to impact valuations, regulators are concerned that private fund managers and investors might have under-estimated the risks in these markets, and that these risks might pose wider problems for financial stability.

The FCA’s concerns are compounded by the perceived opacity of private market investments, with concerns that funds’ quarterly reporting and the accuracy of the valuation of fund assets might not accurately reflect the incentives and risks for investors. Furthermore, investors in private funds are “locked-in” to their investments for longer than in open-ended, regulated funds, and pay higher fees on average, and therefore, the FCA has concerns about protecting individual investors by ensuring that private markets are sufficiently transparent.

We will keep clients informed as further information becomes available.

On 18 September 2023, the Upper Tribunal upheld the First Tier Tribunal’s (FTT) decision on the application of the salaried members’ rules to the investment management (including private funds) context.

The salaried member rules treat a member of a UK LLP as an employee for tax purposes if the below three conditions are met. If a member of a UK LLP satisfies these conditions and is thereby treated as an employee, PAYE obligations will arise on the part of the LLP, which will also incur a liability to class 1 employer and employee National Insurance contributions. The conditions are:

• at the relevant time, it is reasonable to expect that at least 80% of the amount to be paid by an LLP over the reference period to an individual member is disguised salary. Disguised salary includes amounts that are variable but vary without reference to the overall amount of the profits or losses of the LLP, or are not, in practice, affected by the overall amount of those profits and losses;
• the mutual rights and duties of the members of the LLP do not give a member significant influence over the affairs of the LLP; and
• at the relevant time, an individual’s contribution to the LLP is less than 25% of that individual’s disguised salary over the reference period.

In June 2022 the FTT decided the so-called “BlueCrest Case”, which concerned whether the bonuses of members of the LLP - who were portfolio managers, non-portfolio managers and other front office members - constituted disguised salary for the purpose of the Salaried Member conditions. The FTT held that the BlueCrest members were not employees for tax purposes because the “significant influence” condition was not met. In making this finding, the FTT rejected HMRC’s restrictive interpretation of “significant influence”. The Upper Tribunal has affirmed the FTT’s interpretation, and found that the judge did not err in finding that a member may have significant influence over a particular aspect of the affairs of the partnership, rather than over the affairs of the partnership as a whole. Whether significant influence will be found will always depend on the particular facts of the case. Read more about the case and appeal in our analysis note.

The Institutional Limited Partners Association is apparently considering updating its transparency recommendations regarding leverage, in order to capture the increasing use of NAV facilities in private equity portfolios.

NAV facilities, which are secured on the asset portfolio underneath a fund rather than on individual assets or on undrawn commitments (like a bridge facility), rapidly increased in popularity during the Covid-19 lockdowns, as managers sought ways to support portfolio companies and/or fund distributions to LPs ahead of asset disposals. Read our note about tax and structuring considerations relevant to NAV financings.

The ILPA Principles 3.0 already reference NAV facilities, recommending that when a fund closes, the GP discloses to LPs how NAV-secured facilities fit into the overall leverage approach for the fund. ILPA may be considering what disclosures are needed on a more regular basis so that LPs can determine whether changes in a portfolio are attributable to operational changes in the underlying business or accelerated distributions from a NAV facility.

The increasing use of NAV facilities (and separately, an increasing interest in utilising margin loans in relation to listed portfolio companies) indicates a growing pressure on GPs to return cash to investors, irrespective of the wider exit environment.

Our private capital advisory team – “Beyond Legal” – continues to issue original and thought provoking material.

2023 has witnessed interest rates rising to levels not seen since 2009. This is being perceived as a tailwind for private debt funds which lend at floating rates and are, therefore, benefiting from higher interest payments. In turn, such funds are coming under scrutiny from investors who perceive their current generally fixed hurdle rates as “too achievable”.

In this context, Macfarlanes’ private capital advisory team have produced a two part series:

• The first article provides an explanation of hurdles and examines the current arguments for and against increasing hurdles.
• In the second article, we explore possible alternatives to raising hurdles, including:
  • adopting floating rate hurdles;
  • providing that the LP receives some payoff during the catchup period; and
  • employing a tiered carried interest percentage, which increases as the fund achieves prescribed return benchmarks.

We continue to see strong interest in private funds that invest in assets that should ideally be uncorrelated to other asset classes offering diversification and the prospect of alpha. Funds in the litigation sector typically adopt private credit and/or outcome (judgement) sharing strategies.

In that context, class action litigation specialists Pogust Goodhead in the UK have secured a loan in the amount of $552.5m (approximately £450m) to help fund the costs of various cases, including those against two of the world’s biggest mining companies, BHP and Vale.

This loan has been provided by US emerging markets investment manager Gramercy, representing the largest worldwide investment in a law firm and Gramercy’s largest single investment to date. As noted, this speaks to the growing interest in litigation funding, the market for which was recently valued by RationalStat at $15.8bn with an anticipated annual growth rate of nine percent through to 2028.

Participation in litigation funding is attractive to investors owing to the growth of the legal services sector, the number of complex class action suits being pursued and the number of parties looking for cost-effective ways in which to finance lengthy legal battles against well-resourced defendants. These factors, along with the superior returns which non- and low-correlated asset classes can bring, have led the market to what Gramercy’s founder Robert Koenigsberger described as “the sweet spot of litigation funding”. As well as increased interest in this market we expect to see ever-increasingly creative approaches to structuring litigation-backed investments, not least due to some current market uncertainties brought about by the recent PACCAR Inc. case which brought into question the basis on which funders can take a share of case proceeds.

Gramercy’s partnership with Pogust Goodhead will provide financial support for trials due to start next year in which 700,000 Brazilian claimants are seeking compensation from the two mining firms for damage caused by the 2015 collapse of the Fundão Dam, which unleashed more than 43mcubic meters of iron ore waste and mud (tailings) upon the surrounding area. The investment will also support claims on behalf of over 1.3m UK claimants against carmakers involved in the 2015 dieselgate scandal, including BMW and Mini, Fiat Chrysler, Ford, Jaguar Land Rover, Mercedes-Benz, Nissan, Renault and others accused of malpractice. In June 2022, Pogust Goodhead successfully represented claimants in the Volkswagen NOx Emissions Group Litigation, reaching an out-of-court settlement of £193m, and remain committed to holding manufacturers to account for health and environmental damage caused.

Read more about this landmark investment.

On 14 September 2023, the European Commission published a consultation on potentially wide-ranging reforms to the Sustainable Finance Disclosure Regulation (SFDR). The consultation included a targeted questionnaire which requests views on all aspects of the regime, including the SFDR’s aims and impacts on the market, and suggests possible changes such as the creation of an explicit fund labelling regime (as the AMF has called for) and a requirement for all products (and not only ESG products) to make sustainability-related disclosures. The consultation concerns possible changes to the SFDR’s Level 1 legislation.

The ESAs are separately considering changes to the Level 2 legislation and the SFDR’s reporting templates. The Commission is not likely to announce its intentions for reform until early-to-mid 2024 at the earliest. Read more about the consultation and its relation to the UK’s upcoming ESG regime in our analysis note.

On 6 September, the ESAs announced a Common Supervisory Action (CSA) on sustainability-related disclosures and the integration of sustainability-related risks. ESMA, EIOPA, and the EBA will work with national competent authorities to assess compliance with the SFDR, the Taxonomy Regulation, and the UCITS and AIFMD requirements in relation to ESG.

The ESAs will design a common methodology to ensure consistent assessment across the EU, with an aim to reinforcing consistent implementation of the regulations. The CSA will continue until the third quarter of 2024.

The European Union has enacted a set of rules targeting ex-EU subsidies, the Foreign Subsidies Regulation. The regime introduces a new regulatory approval process that may apply to investment funds acquiring control over businesses with significant EU revenues and controlled portfolio companies active in public tenders. On 12 October 2023, the notification obligations under this regime come into force. More information on those obligations and their impact on businesses can be found in our article.

2023 has witnessed a slowdown in commitments to private assets from German insurance investors, who have historically been motivate investors owing to low interest rates available from fixed-income products. In light of the current higher interest rate environment, our corporate advisory team have provided a helpful summary of the key concerns which motivate German insurance investors and points for GPs to consider when marketing to this audience.

Over the past 18 months, the Dubai and Abu Dhabi regulators have created frameworks within which private credit funds can operate in those jurisdictions and lend to Middle Eastern SMEs. The Maples Group have provided this helpful note on the regulatory requirements for such funds. For example, in Dubai, a credit fund will require a Fund Manager regulated by the Dubai Financial Services Authority, may only market to professional investors and must be open for no longer than 10 years.