Introduction

Into 2023, the private equity industry continued to face macroeconomic and geopolitical challenges. While the crisis around the collapse of Silicon Valley Bank, First Republic Bank and Signature Bank was not protracted, it nonetheless compounded an already difficult liquidity environment. Fundraising remains highly competitive. The polarisation around ESG in the United States has intensified, resulting in a patchwork of wildly different state legislation. The SEC continues to take aim at private fund practices. In this environment, caution rules the day for both sponsors and investors.

And yet, with creativity and persistence, deals are getting done. Lenders are adjusting their balance sheet exposures. Direct lending and co-investments, as well as innovative deal structures, help to fill the financing gaps caused by the pullback in syndicated debt financings. Brand-name funds are weathering fundraising headwinds by offering incentives and flexibility with terms, while first-time managers are building track records by raising capital deal by deal. And through it all, bright spots have begun to appear.

Fundraising

Investment managers and investors seeking a return to strong private market fundamentals in 2023 have instead been met with a stubbornly persistent inflationary environment, continued pressure on public equities, banking and tech sectors roiled by bank failures and government interventions, rising geopolitical tensions across the globe and a slew of complex and burdensome new laws and regulatory proposals. These conditions have made the fundraising market as competitive as ever, and sponsors across industries and geographies are battling these headwinds in the search for allocations from investors who are struggling with the denominator effect and a lack of liquidity across their portfolios.

Notwithstanding these conditions, established sponsors with proven track records of delivering strong returns across a variety of market conditions have reason to be optimistic. These sponsors are capturing an outsize share of investor allocations in today’s tough fundraising environment, particularly for existing products that may only come to market every two to three years. Banner products remain attractive, and investors are carefully managing their capital to ensure they can participate in these funds when they come to market. But even flagship funds are taking longer to raise and require flexibility and creativity with fund marketing and terms. Emerging managers, on the other hand, face some of the tightest fundraising conditions in the market today. Increasingly, first-time managers are raising capital deal by deal in order to build a track record and ride out the current fundraising environment.

In the first half of the year, sponsors have been offering economic incentives and other accommodations that were less common over the past several years. For example, loyalty discounts are being offered more broadly and at lower thresholds. Early closing discounts are increasingly likely to continue past the fund’s initial closing, often until the date of the fund’s first investment or when the management fee commences. Sponsors are also more likely to shorten a fund’s investment period, explore stapling a newer product to a more durable established fund, raise smaller “bridge” or “annex” funds or address more customised requests from anchor investors.

At the same time, more investors are seeking staged commitments in lieu of a large up-front allocation, which can aid their cash planning and provide better visibility into a fund’s early performance as it approaches the end of a 12 to 18-month fundraising period. Investors are also looking for more exposure to separately managed accounts or other co-investment opportunities that can reduce the cost of their investment with a manager.

In the midst of this private market slowdown, sponsors are also adjusting to a meaningful uptick in regulatory requirements. The SEC’s new Marketing Rule in particular has introduced cost and complexity for sponsors, and the market is still adapting to this new paradigm, as well as a slew of other proposed and recently enacted regulation. International, US and state ESG rules have also continued to develop at a steady pace but without a uniform approach across borders or common sentiment among investors. Against this backdrop, sponsors and investors alike are struggling to develop effective tools for evaluating the impact of, and implementing procedures to address, these rules and proposals on the private fund industry.

The private market also continues to grapple with the effects of the banking crisis. Liquidity and access to capital were already tight in the beginning of the year, and the failures of multiple regional banks in the spring and the resulting government interventions only exacerbated that tension. Private funds in the venture, growth and tech sectors were particularly exposed to this segment of the banking market, and they now struggle to replace those sources of capital for their own funds and their portfolio companies.

It is expected that many of these conditions will persist in the second half of 2023 and thus prolong the slow pace of fundraising. Strong performance and creativity will be essential for sponsors to successfully attract capital. The private fund industry continues to be a people business, and it is expected that relationships between sponsors and investors will be more important than ever as participants continue to grapple with macro factors beyond their control.

Fund Finance

The first half of 2023 was, to put it mildly, an interesting time in the fund finance market. The impending failures of Silicon Valley Bank, Signature Bank and First Republic Bank – all notable lenders in the fund finance space – sent fund borrowers scrambling to navigate covenants and restrictions in their credit facilities with these banks and searching for alternative credit sources. At the same time, investors rightfully expressed concerns about funding contributions into deposit accounts at these banks, putting fund borrowers in the uncomfortable position of choosing compliance with credit facility covenants over the interests of their investors. But the crisis was short lived, and the credit facilities largely performed with relatively minimal disruption.

Despite – or perhaps because of – the pullback by the regional banks, there continues to be strong demand from funds to fill their liquidity needs (and in the case of newer funds, those demands sometimes go unmet). However, bank lenders that traditionally have been major players in the fund finance market continue to be buffeted by a series of macroeconomic events – including the increase in interest rates and regulatory changes in capital treatment – and remain more selective with credit extensions. This trend started in the latter half of 2022 and persists to date (publication of this guide, September 2023).

An increased focus on syndication efforts, via assignment or participation, continues to be seen. Lenders are also looking to readjust their balance sheet exposures by means of swaps, financial guarantees or other similar transactions. Accordingly, market players have been revisiting the relevant provisions in their facility documents to accommodate such processes.

In addition to subscription facilities, the continued popularity of back-leverage loans and NAV facilities by buyout funds was observed. With the leveraged finance markets disrupted, sponsors increasingly turned to these products to consummate acquisitions, purchase portfolio company debt and make distributions to limited partners in view of delayed exits from portfolio companies. Conditionality for these structures also continues to evolve, with some lenders willing to consider providing these facilities with limited conditions similar to that for opco-level facilities. More alternative fund finance credit providers were observed offering these facilities.

Sponsors continue to raise capital from insurance companies and similar investors. While 2023 has seen a slowdown in activity in view of market conditions and uncertainty over regulatory developments, it is expected that rated feeder structures and other structured products, such as collateralised fund obligations, will continue to evolve and develop. If history is any guide, innovation in the fund finance market will continue so long as sponsors have unmet liquidity needs.

Funds Regulatory

The SEC’s Spring 2023 Regulatory Agenda and rule-making activity have signalled that there is no let-up in the agency’s breakneck rule-making pace. The Spring Agenda’s 55 items included 18 items at the proposed rule-making stage and 37 items at the final rule stage. The Fall 2023 agenda is expected to reflect similar priorities, continuing the momentum from the Fall 2022 Regulatory Agenda, which included 52 items. Notably, the preamble to the Spring Agenda states this reflects “only the priorities of the Chair of the U.S. Securities and Exchange Commission, and [does] not necessarily reflect the views and priorities of any individual Commissioner”, which suggests that proposal and adoption of any particular rule is not guaranteed.

Newly adopted Rules

In August of 2023, the SEC adopted the Private Fund Adviser Rules, ushering in sweeping changes for the private funds industry. The rules regulate substantive contractual terms applicable to private funds and impose certain conduct and disclosure requirements on advisers with respect to their private fund clients.

Newly proposed Rules

• Predictive Data Analytics: would seek to regulate investment adviser and broker-dealer conflicts when predictive data analytics, artificial intelligence, machine learning and other “covered technologies” (defined broadly) are used in certain investor interactions. 
• Registration for Internet Advisers: would amend the exemption for internet advisers from the prohibition against registration under the Advisers Act.

Previously proposed Rules with a target adoption date of Autumn 2023

• ESG Rule: as proposed, enhances the disclosure requirements for investment company fund filings and investment advisers’ Form ADV regarding ESG strategies.
• Cybersecurity Rule: as proposed, requires advisers and funds to adopt and implement written policies and procedures that are reasonably designed to address cybersecurity risks and to provide additional disclosures related to such risks and incidents in investment adviser brochures and fund filings. Although previously expected to be adopted in spring 2023, the Spring Agenda indicates an autumn 2023 adoption date.
• Safeguarding Rule: as proposed, significantly broadens the application of existing rule 206(4)-2 (the “Custody Rule”) in a new rule, 223-1 to cover a wider range of assets and more closely regulate the relationship between an adviser and its custodian. While the SEC’s target for final action on this proposal rule is autumn 2023, it is anticipated that the final rule is more likely to be adopted in 2024.

Previously proposed Rules with a target adoption date of Spring 2024

• Outsourcing by Investment Advisers: as proposed, requires investment advisers to:
1. conduct due diligence before outsourcing various functions;
2. monitor and reassess service providers’ performance; and
3. make and keep books and records related to such due diligence and monitoring.

This is a shift in timing from the Fall 2022 Agenda, which listed an adoption date of spring 2023.

• Regulation Best Execution: would amend and enhance the existing best execution framework by requiring detailed policies and procedures for broker dealers engaging in certain conflicted transactions with retail customers.

Rules covered in the Spring 2023 Agenda for potential proposal in Autumn 2023

• Regulation D Rule: would seek to update the accredited investor definition in Rule 501 under the Securities Act of 1933 and Form D to improve protections for investors. However, three bills have passed the House that suggest Congress may have its own ideas on how the definition of “accredited investor” should be revised (although as of this writing they are in review by the Senate):
1. the Equal Opportunity for All Investors Act (HR 2797) would update the definition to include individuals certified through an examination established by the SEC and administered by FINRA;
2. the Accredited Investor Definition Review Act (HR 1579) would require the SEC to update the list of certifications (including the “millionaire requirement”) that an investor must satisfy to qualify as an accredited investor; and
3. the Fair Investment Opportunities for Professional Experts Act (HR 835) would allow investors with certain licences or educational or professional backgrounds to qualify as “accredited investors”.
• Securities Held of Record Rule: would amend the “held of record” definition in the Securities Exchange Act of 1934 and recalibrate the way issuers must count shareholders of record under Section 12(g).

The Spring Agenda does not include seven rules adopted since the Fall 2022 Agenda, including the share repurchase disclosure modernisation amendments, which will require an issuer to provide more timely disclosure on the new Form SR regarding purchases of its equity securities for each day that the issuer, or an affiliated purchaser, makes a share repurchase.

A note on the Marketing Rule

On 8 June 2023, the SEC’s Division of Examinations issued a Risk Alert in connection with the amendments to Rule 206(4)-1 under the Advisers Act. The Risk Alert does not provide any new guidance for investment advisers. Instead, the Risk Alert notes that while the SEC staff remains focused on the exam areas outlined in the prior marketing rule risk alert, it is also increasing its focus on other areas during examinations including on testimonials and endorsements, third-party ratings and the amended Form ADV. However, the Risk Alert’s lack of any new or specific issues of concern suggests that it is sufficient for investment advisers to continue their existing Marketing Rule compliance efforts and that no additional procedures are needed at the moment.

Private Funds Transactions

While markets have stabilised compared to peak 2022 volatility, high interest rates, infrequent distributions and difficult fundraising environments continue to impact the secondaries market.

Single-asset GP-led transaction volume continues to lag due to a material bid-ask spread in pricing between secondary investors and sponsors as well as challenges in raising the full equity check required to close larger transactions. Many financial intermediaries have advised sponsors to defer single-asset transactions with values over USD1 billion until the fundraising environment improves. Anecdotal guidance from those intermediaries suggests optimism that the growing need for investor liquidity will eventually outweigh the bid-ask spread, leading to an uptick in GP-led secondaries volume to close the year.

GP-led transactions successfully completed in the first half of 2023 continued to evidence a buyer’s market. Outside the highest performing assets, where there is still competition for allocations, lead buyers frequently negotiated discounts to NAV and comparatively lower management-fee rates while exercising more control over continuation fund governance terms. “Super-carry” (ie, a top-end distribution waterfall tier providing the GP with more than 20% of profit), which was common during the single-asset GP-led transaction boom of 2021, is now increasingly rare. Non-traditional buyers (ie, investors in other than funds of funds) continue to enter this space, accelerating the trend toward the use of more M&A-like features in GP-led transactions – most notably an increased focus on asset-level diligence and seller representations and warranties, including more widespread use of representation-and-warranty insurance.

At the same time, LP portfolio sales have seen a significant uptick, driven by a distribution-light environment, comparative stabilisation of PE valuations and pension investors that grappled with the denominator effect at the close of 2022 and start of 2023. Broad investor need for liquidity has precipitated a wide array of portfolios coming to market, even with certain strategies, including venture, growth and energy, continuing to trade at significant discounts. By comparison, blue-chip portfolios have fared better, with discounts to NAV shrinking over the past year. For larger, diversified portfolios, it is becoming increasingly rare for a seller to engage with a single buyer. As the universe of secondary buyers continues to segment and specialise, financial intermediaries are able to achieve higher, blended portfolio pricing by engaging with multiple, unrelated buyers. Indicative of current fundraising challenges, sponsors have once again started to ask buyers of LP interests to make stapled commitments to their newer funds.

Co-investment appetite remains strong and has adapted to macroeconomic conditions and evolutions in private fund and deal-making technology. As GPs are holding onto portfolio companies for a longer period and seeking to build larger, higher-multiple portfolio companies through add-on acquisitions in pursuit of a more favourable exit at a later date, GPs have increasingly turned to co-investors for follow-on capital. Experienced co-investors have been more willing to undertake bespoke direct investments, such as mid-life investments through direct lending or preferred equity. In some cases, investors are finding mid-life co-investments as attractive alternatives to GP-led secondaries, as they do not require a reset of economics and can allow an investor to negotiate preferred returns and enhanced governance rights in an existing no-fee, no-carry structure. Private credit has thrived, with both sponsors and investors building out lending platforms, driven by the surge in opportunities and the pursuit of portfolio diversification. There has been a rise in captive opportunities where sponsors’ equity and credit arms co-exist within one portfolio investment. Such arrangements, however, give rise to concerns over how sponsors will manage conflicts of interest where the two arms are not aligned, along with a push from co-investors to participate in such opportunities to prevent dilution or subordination and maintain alignment with sponsors.

The biggest story for the second half of the year, however, could be new rules under the Advisers Act, which the SEC previewed last year, including a possible prohibition on non-pro rata allocation of broken deal expenses. Such a rule, if implemented across all deals and all participants, is likely to drastically change current market practice (at least in the United States), where allocation is negotiated based on the nuances of a deal, such as whether a co-investor is co-underwriting versus participating in a post-signing syndication.

M&A

On passing the midyear point of 2023, a pick-up in private equity M&A activity is still awaited. The post-COVID hangover of 2022, precipitated by dislocations in the debt financing markets, has endured into 2023. While there have been pockets of activity in certain sectors of the market, total private equity deal volume for the first half of 2023 has returned to pre-COVID levels, in line with the global slump in M&A generally, which hit a three-year low in the first half of 2023.

Early hopes for a rebound were also tempered by the regulatory climate, as the Biden administration’s FTC and DOJ have not wavered in their scrutiny of private equity deals. Some potential roll-ups and other transformative acquisitions by portfolio companies have been scuttled for fear of a protracted approval process, as sponsors find it difficult to secure committed financing at an acceptable cost when the sign-to-close period has the potential to stretch on for a year or more.

Yet, even in the face of economic and regulatory uncertainty and choppy debt markets, deals are getting done, especially when creative approaches are deployed. In certain sectors, such as healthcare and infrastructure, sponsors have been able to finance acquisitions on acceptable terms, albeit at relatively lower leverage ratios than before 2022. Direct lenders have stepped up as major players, rather than supporting cast members to syndicated lenders. Co-investments are also playing a bigger role in the financing of some deals, as sponsors put less leverage on target companies. Sponsors are also deploying earn-outs and significant rollovers more frequently to bridge valuation mismatches, taking on minority investments and doing co-control deals with incumbent sponsors where existing debt with attractive interest rates can remain in place. Fund-to-fund and continuation fund deals have also remained popular.

However, notwithstanding pockets of activity and innovative structures, the current environment remains one in which buyers are often exercising caution and finding reasons not to do deals rather than racing to signings out of fear of missing out.

Looking to the rest of the year, long-in-the-tooth fund assets are starting to be brought to market, perhaps reflecting pressure on sponsors to return money to LPs combined with a recognition that conditions and valuations are not likely to change dramatically in the near future. This development may lead to a more frequent meeting of the minds on price than has been seen in the past 18 months and, together with the continued use of the transaction structures described above, could set the stage for an uptick in deal volume.

SEC Enforcement

In 2023, the US Securities and Exchange Commission has continued to bring enforcement actions against entities advising and auditing private funds, signalling its continued focus on cross-trades, valuation practices and management-fee calculations. Three of the year’s most notable actions are reviewed below.

In April 2023, the SEC brought an action against Chatham Asset Management for alleged improper trading in certain fixed income securities related to both its hedge funds and several registered investment companies for which it served as sub-adviser. The firm’s clients were heavily invested in illiquid bonds, and in the ordinary course of effecting fund account redemptions, Chatham engaged in allegedly improper dealer-interposed cross-trades in which one Chatham fund purchased the same bonds that another Chatham fund purchased through certain broker-dealers. To make these trades, Chatham allegedly proposed the bond prices to the broker-dealers, and the broker-dealers agreed to the proposed prices with the knowledge that Chatham would repurchase the bonds either directly or indirectly through another broker-dealer. Through this practice, Chatham allegedly charged clients approximately USD11 million in additional fees that they would not have paid in the absence of those trades. The SEC noted its concern regarding the pricing of these trades – namely, that Chatham had chosen the inflated prices at which the bonds were cross-traded. The SEC found that Chatham violated Section 206(2) of the Investment Advisers Act of 1940 and Section 17(a)(1) and (a)(2) of the Investment Company Act of 1940. Chatham’s principal, Anthony Melchiorre, was charged with aiding and abetting these violations.

In another spring 2023 action, the SEC brought settled charges against Spicer Jeffries and one of its audit partners for improper professional conduct related to two private fund audits. The SEC alleged that during the audit planning stages, Spicer Jeffries assessed that valuation of investments was a significant fraud risk but did not implement the planned audit approach to respond to the risk. According to the SEC’s order, due to these failures and others, Spicer Jeffries did not exercise due care including professional scepticism related to the adviser’s fair-value measurements. The order also found that Spicer Jeffries’ deficient system of quality control led the firm to fail to adhere to professional auditing standards. As part of the settlement, Spicer Jeffries agreed to issue a firm-wide announcement about the case approved by the SEC and to retain an independent consultant to review and evaluate the firm’s audit, review and quality-control policies and procedures, along with several related undertakings. The audit partner also agreed to a one-year suspension from appearing and practising before the SEC. This action highlights the SEC’s continued focus on gatekeepers in the private fund context.

The SEC has continued to prioritise reviews of private fund advisers’ calculation of post-commitment management fees, and, in June 2023, announced an action against Insight Venture Management LLC in which the firm agreed to pay a USD1.5 million penalty to settle charges that the firm had calculated management fees in a manner not in conformance with the fund documents. Specifically, the order found that Insight inaccurately calculated management fees based on aggregated invested capital at the portfolio company level instead of at the individual portfolio investment security level, as required by the applicable limited partnership agreements. In addition, the SEC found that the firm failed to disclose a conflict of interest relating to the firm’s discretion in determining whether an asset would be considered permanently impaired so as to reduce the basis used to calculate management fees. Notably, the case started as a referral by the Division of Examinations to Enforcement – thus serving as a reminder to private fund managers that fee calculations remain in the crosshairs during SEC examinations and that the firm’s fee calculations must be aligned with fee disclosures in the relevant fund documents.

Looking ahead, continued robust enforcement against private fund advisers is expected, especially in instances where there is a perceived conflict of interest or an issue with the calculation of management fees.