Overview

In the beginning of 2024, the year ahead was viewed with "guarded optimism." From the vantage point of the third quarter, that perspective has been borne out. Private equity M&A deal activity in the USA has gathered steam, and while the market in Europe is still finding its stride, sponsors investing there are finding opportunity in certain sectors and market niches. The robust secondaries market continues to fill the gap where attractive exit opportunities are not available via the IPO market or third-party sales. Positive momentum on the dealmaking front is in turn giving sponsors hope that the fundraising environment may begin to warm.

But if market conditions are gradually becoming more stable (and favourable), the regulatory and enforcement environment is another matter. ESG-related regulations in the EU and UK are an ever-evolving landscape, while in the USA they provide the stage for increasingly polarised legislative battles. At the end of June, the US Supreme Court issued two decisions with the potential to significantly upend the regulatory and enforcement environment: one holding that courts no longer must defer to an agency’s interpretation of regulations, and the other calling into question the SEC’s ability to pursue penalties through its in-house administrative proceedings. Both decisions promise to bring uncertainty and unintended consequences.

Fundraising

The fundraising market is beginning to benefit from the improved financial conditions that have slowly brought dealmakers back to the table. Transactional markets – particularly in the USA and Europe – gradually began to thaw over the first half of 2024, and there is a cautious optimism that the uptick in deal activity will persist throughout 2024 and accelerate in 2025. That outlook gives fund sponsors and investors hope of unlocking liquidity and is creating a bit of momentum for new funds across asset classes. While raising capital is still taking longer than it did in 2020 and 2021, and remains challenging amidst macroeconomic uncertainty, the market is warming a bit – particularly for larger fund managers and funds targeting more than USD1 billion.

To that end, the private funds market continues concentrating in brand name mega funds where investors believe there is both opportunity and more certainty. While these funds are not immune to the challenges of this fundraising environment, they have weathered it better than most. That durability improves their outlook for the remainder of the year and beyond.

Conversely, middle market and smaller firms continue to face prolonged capital-raising periods for funds launched over the past two years. A number of these firms have extended fundraising periods, offered or expanded fee reductions, and customised other offers to attract investors. Patience and creativity have been essential given the number of investors facing a liquidity crunch and reducing their private fund allocations or the number of managers they partner with.

The first half of 2024 also saw investors focusing on asset classes and sectors with countercyclical characteristics – or that would be too risky to pass up. Private credit funds continued to attract capital, offering a safe haven and an opportunity to achieve equity-like returns in today’s "higher for longer" interest rate environment. Open-end credit funds have been particularly appealing as a source of more predictable liquidity, and many sponsors in the market have been very active in the space. In another vein, AI is the opportunity no firm wants to miss. The technology is already so pervasive, and the transformational opportunity so evident, that sponsors throughout the private markets are trying to catch AI tailwinds that may boost their portfolios. That has made AI a very bright spot across the dealmaking and fundraising markets, from early-stage venture funds to later-stage growth and private equity funds.

Also continuing is strong interest in secondaries funds – perhaps not surprising, given that traditional exit routes have been so limited – and secondary exits have surged. The secondaries mega funds have been scaling, and managers continue to introduce new fund products, to capture a portion of this growing market.

Some sponsors are waiting for conditions to improve prior to launching new products in hopes of avoiding some of the market’s current supply-and-demand imbalance. Others are moving more aggressively into retail capital, which presents an enormous opportunity for sponsors equipped to pursue it. It is expected the trend will persist, and for sponsors to continue seeking new distribution channels that could unlock capital and provide a bulwark against future downturns.

While caution remains the theme of 2024, there are the fledging signs of optimism, opportunity and signs of liquidity in several areas in the market.

Private Funds Transaction

The secondaries market has been seeing an uptick in venture capital (VC), credit and strip sale continuation fund transactions – and the growing popularity of these transactions has prompted existing co-investors to seek additional protections.

Venture capital continuation fund transactions

The venture capital GP-led secondaries market has picked up momentum, as investors seek liquidity amidst a slow market for IPOs and traditional M&A exits. While there were a few noteworthy VC continuation fund transactions in 2022 and 2023, 2024 has been characterised by a significant uptick in activity. This trend is expected to continue, as the last 12 months have seen existing sponsors in the VC secondaries market close funds significantly larger than their predecessor funds and new sponsors enter this part of the secondaries market. As before, pricing remains a challenge, however, as the bid-ask spread for VC assets continues to be one of the widest of all asset classes in the secondaries market. There has also been an increase in VC secondaries funds designing bespoke liquidity solutions for founders, employees and other early investors in VC-backed companies, providing those funds an additional avenue for accessing investment opportunities in target companies. For example, a fund may enter into a financing arrangement with such individuals secured by a pledge of securities in the target company in return for a negotiated minimum return coupled with an incentive payment at the time of an IPO or sale of the target company.

Credit continuation fund transactions

While there has been considerable discussion over the last couple of years regarding the impending rise of the credit GP-led secondaries market, activity during much of that period was overwhelmingly concentrated in traditional portfolio deals and NAV loans. However, the last six months has seen several significant credit continuation fund transactions come to market. Credit secondaries transactions will typically involve a highly diversified portfolio that is principally comprised of numerous debt investments and a comparatively small number of post-reorganisation equity positions. Legacy limited partner (LP) selling volume is difficult to predict at this stage, but anecdotally, legacy LP interest in liquidity with respect to credit portfolios has been somewhat muted in comparison to single-asset equity continuation fund transactions, where legacy LP selling volume has generally remained in the 80%-90% range for a number of years.

Strip sale continuation fund transactions

Over the last 12 months, there has been a notable uptick in strip sale transactions, that is, transactions in which a sponsor causes the selling fund to sell only a portion of one or more existing portfolio investments to a continuation fund. Typically, in a strip sale transaction, there is no rollover or reinvestment option offered to legacy LPs and the sponsor will seek to align the legacy fund’s and continuation fund’s exits from the commonly held portfolio investments. Particularly when sponsors are not concerned about an impending end of the legacy fund’s term or about a lack of go-forward capital to support portfolio investment growth, strip sale transactions provide one way to boost the legacy fund’s Distribution to Paid-In Capital ratio – and do so more quickly than typical continuation fund transactions due to the absence of an LP election process. 

Co-investors in continuation funds

The treatment of co-investors in LP election processes for continuation funds remains an issue for negotiation between sponsors and co-investors. Many sponsors have been unwilling, at the outset of a co-investment, to take a position on whether co-investors would be given the option to either exit, to maintain the status quo (ie, remain invested through a fee and carry-free co-invest vehicle) or to subscribe to a continuation fund with different economics. Instead, those sponsors have preferred to retain for themselves the right to decide at the time they undertake the continuation fund transaction whether to "drag" the co-investors along or to offer them an option to cash out. Co-investors, on the other hand, would like more certainty at the outset regarding their options in the event a continuation fund is organised, including the ability to preserve the economics they have under the terms of the original co-investment. Market terms on this point remain in flux.

M&A

The first half of 2024 has brought an uptick in US private equity M&A deal activity. Although the number of completed deals remains below that of 2021 and early 2022, thus far 2024 would have been considered healthy deal activity in prior periods.

Buyers and sellers are closer, in general, to a meeting of the minds on price than they have been in some time, even if interest rates continue to present a challenge to PE buyers in modeling attractive returns at a price that will motivate a seller. Debt financing has been reasonably available, and the expectation that rates will remain where they are for at least the medium term – ie, that there is a "new normal" –  has prodded parties into action and off the sidelines waiting for rates to drop.

Given elevated public equity valuations, take-private deal volume had fallen off considerably during the beginning of 2024 (despite certain mega deals, such as Silver Lake’s agreement to take Endeavor private), with sponsors instead focusing on carve-out and add-on deals, but there has been a resurgence of interest in take-privates in Q2. At the exit end of the life cycle, sale processes are being initiated more frequently today than in the prior 18 months (including for some long-in-the-tooth assets), though with mixed results.

There continues to be a substantial number of continuation fund deals, which appear to have established themselves as a permanent part of the PE landscape. The combination of new third-party capital and continued control for the sponsor that these funds offer is particularly appealing in a still somewhat challenged dealmaking environment.

The regulatory environment remains a focus for market participants. While the threat of regulatory action isn’t preventing deals from signing, the practical realities of dealmaking in an era of aggressive regulation can be seen in the amount of time and energy spent in negotiating terms such as efforts covenants, closing conditions and reverse termination fees.

Although 2024 has yet to unleash the torrent of activity some have hoped for, the war chests of dry powder held by sponsors, along with a period of relative stability in the debt markets, lead to the expectation that the gradual increase in US private equity M&A activity will continue. There is always the possibility of pre-election skittishness disrupting these generally favourable conditions, but so far there has been no evidence of that bearing out.

SEC Enforcement

The first half of 2024 saw two developments regarding SEC enforcement that have particular importance for the private equity industry: the US Supreme Court’s ruling in SEC v Jarkesy regarding the SEC’s in-house administrative proceedings, and the settled enforcement action by the SEC against J.P. Morgan Securities for violating SEC whistleblower anti-impediment rules.

SEC v Jarkesy

On 27 June 2024, the U.S. Supreme Court issued its highly anticipated ruling in SEC v Jarkesy, holding in a six-to-three ruling authored by Chief Justice Roberts that the Seventh Amendment right to a jury trial precludes the SEC from pursuing penalties for securities fraud violations through in-house administrative proceedings in which an administrative law judge (ALJ) makes factual findings.

In 2013, the SEC instituted administrative proceedings against George Jarkesy and his investment adviser, Patriot28, in connection with two hedge funds advised by Patriot28, alleging that Jarkesy and Patriot28 violated the antifraud provisions of the federal securities laws through various misrepresentations to investors. After an ALJ found for the SEC, both respondents petitioned the Commission for review (which operates as a de novo appeal of the ALJ’s decision). After six years, in 2020, the Commission affirmed the ALJ’s finding; the SEC then imposed cease-and-desist orders on Jarkesy and Patriot28, ordered Jarkesy and Patriot28 to pay a USD300,000 penalty and Patriot28 to pay disgorgement of more than USD680,000, and prohibited Jarkesy from further involvement in the securities industry.

Jarkesy and Patriot28 appealed the Commission’s agency’s decision to the US Court of Appeals for the Fifth Circuit, which ruled in the two respondents’ favour, holding, among other things, that in the SEC’s administrative proceedings, Jarkesy and Patriot28 were deprived of their constitutional right to a jury trial. The SEC appealed the Fifth Circuit’s decision to the US Supreme Court, which granted certiorari.

On 27 June 2024, the Supreme Court affirmed the Fifth Circuit ruling, holding that Jarkesy and Patriot28 had been deprived of their right to a jury trial. The majority opinion pointed to prior holdings that the right to a jury trial extends to statutory claims that are "legal in nature," which the Court then determined the SEC’s civil monetary penalties to be, since their purpose is to punish and deter the wrongdoer rather than to make the victim whole.

The implications of this ruling are significant for the securities industry and administrative agencies in general (including, potentially, for Self-Regulatory Organisations, such as FINRA, that have in-house administrative hearing functions). Although the Jarkesy decision itself only concerned the constitutionality of litigating alleged fraud violations before an ALJ, the Supreme Court’s reasoning with respect to monetary remedies certainly calls into doubt the ability of the SEC to obtain civil penalties in an administrative proceeding for any violation of the federal securities laws.

As a practical matter, it is expected that the Commission will continue to bring all litigated enforcement matters before federal district court, as it has for several years (with certain narrow exceptions where district courts lack jurisdiction). Any such administrative proceedings likely will be challenged under Jarkesy on Seventh Amendment grounds (as well as on other grounds in the Fifth Circuit’s decision on which the Supreme Court did not rule).

Whistleblower Anti-impediment Rules

In January 2024, the SEC ordered J.P. Morgan Securities (JPMS) to pay an USD18 million civil penalty for including a provision in its release agreements with retail clients in which the clients "promised not to sue or solicit others to institute any action or proceeding against JPMS arising out of events concerning" their accounts. Although the agreements expressly permitted JPMS clients to respond to inquiries made by the SEC or any other government or self-regulatory entity, the agreement did not include a provision that expressly permitted clients to voluntarily report information to SEC staff without risking legal action. The SEC determined that the absence of explicit language protecting whistleblowers with respect to the confidentiality requirements was a violation of Rule 21F-17(a) of the Securities Exchange Act of 1934, which prohibits impeding individuals from reporting potential securities law violations to the SEC. Notably, the ruling expands the focus of the SEC’s whistleblower protections beyond employees to include investors.

Given this broadening of focus – not to mention the current SEC sweep underway to assess adviser compliance with Rule 21F-17(a) – private equity firms and their holding companies (whether public or private) should review documents across their businesses to make sure that they appropriately carve out whistleblowing activities from their confidentiality and other restrictions. Such documents may include:

• employment-related agreements (eg, employment agreements, separation agreements, confidentiality agreements, restrictive covenant agreements, equity agreements);
• consulting agreements;
• confidentiality agreements/NDAs with individuals;
• policies (eg, compliance manuals; codes of conduct; employee handbooks);
• training materials;
• brokerage customer and advisory client releases/settlement agreements; and
• limited partnership agreements and other forms of investor agreements.

Recent actions underscore the need to avoid even the appearance of impeding whistleblowing through impermissibly restrictive language, conflicting terms, or the lack of explicit whistleblower protections and assurances. Companies also should consult with counsel regarding the most effective way to address any existing or past agreements or other documents that could be read to prohibit or otherwise have a chilling effect on an individual’s ability to provide information to or communicate with the SEC or other government agencies.

US Funds Regulatory

The first half of 2024 has seen several important developments in the U.S. regulatory landscape, including the striking down of the Private Fund Adviser Rules and SEC sweeps regarding the Marketing Rule.

Private fund adviser rules vacated

On 5 June 2024, the US Court of Appeals for the Fifth Circuit unanimously struck down the controversial Private Fund Adviser Rules that would have radically changed the SEC’s historical disclosure-based approach to the regulation of private fund advisers.

The court’s decision was based solely on its holding that the SEC did not have the authority under Advisers Act Section 211(h) and Section 206(4) to promulgate the rules. The court held that Section 211(h) "has nothing to do with private funds" because it applies to "retail customers" only. The court also found that the rules were not supported by the SEC’s general antifraud authority under Section 206(4) of the Advisers Act because the SEC had not articulated a "rational connection" between fraud and any part of the rules. Given its holding that the SEC exceeded its authority, the court did not opine on the industry’s arguments that:

• the SEC failed to provide the public a meaningful opportunity to comment on the adopted rules;
• the rules are arbitrary, capricious and otherwise unlawful; and
• the SEC did not perform an adequate cost-benefit analysis.

The deadlines for the SEC to seek a rehearing or appeal have passed, but despite the loss the SEC’s focus on private funds is likely to continue. The principles behind the rules remain indicative of the SEC’s views on many industry practices and potential areas of focus for Advisers Act exams and enforcement going forward. Parts of vacated rules may also continue to surface as investor requests in negotiations, and private fund advisers should be prepared to address investor requests that reflect certain principles underlying the Private Fund Adviser Rules.

The SEC’s Spring 2024 Regulatory Agenda includes a target date of October 2024 for final rules with respect to the proposed Cybersecurity Risk Management Rule and Outsourcing Rule, as well as for re-proposing the Predictive Data Analytics Rule, each of which would apply to private fund advisers and relies at least in part on Section 211(h) as authority for the rulemaking. The industry groups that brought the Private Fund Adviser Rules litigation submitted a letter to the SEC encouraging the regulator to withdraw these three proposals, indicating that if adopted they could face similar legal challenges. It is also unclear whether any of the court’s conclusions will be read to apply to any existing Advisers Act rules or SEC interpretations.

Marketing Rule

The SEC’s Marketing Rule sweep continues to result in enforcement activity. On 17 April 2024, Division of Examinations released a new risk alert on the Marketing Rule – its third since the rule’s 4 May 2021 effective date – which summarises some of the deficiencies observed during the sweep.

The risk alert closely follows the 12 April 2024 announcement of settled charges against five registered investment advisers for Marketing Rule violations. The SEC’s orders found that each of the five advisers failed to comply with Marketing Rule requirements by advertising hypothetical performance to the general public on their websites without adopting and implementing policies and procedures reasonably designed to ensure that the hypothetical performance was relevant to the likely financial situation and investment objectives of each advertisement’s intended audience. Four of the five registered investment advisors received reduced penalties because of the corrective steps they undertook before being contacted by the SEC staff. The SEC also found that one of the five additionally committed a much longer list of rule violations, including making false and misleading statements in advertisements, advertising misleading model performance, being unable to substantiate performance, failing to enter into written agreements with people it compensated for endorsements, committing recordkeeping and compliance violations, and making misleading statements about its performance to a registered investment company client, which, in turn, were included in such client’s prospectus.

The settled charges against those five registered investment advisors were preceded by Marketing Rule-related enforcement actions against nine other registered investment advisers settled in September of last year. Again, the SEC’s orders found that each of the advisers advertised hypothetical performance to mass audiences on their websites without having the required policies and procedures. In addition, two of the advisers failed to maintain required copies of their advertisements.

More recently, on 14 June 2024, the SEC settled another Marketing Rule enforcement action against a registered investment adviser, this time for performance advertising that was misleading and not fair and balanced. The adviser was found to have presented performance returns that were experienced by a single investor without disclosing that such investor’s elevated performance was due to participation in IPOs in which many other fund investors did not participate. And on 9 August 2024, another registered investment adviser settled an enforcement action relating to its presentation of hypothetical performance on its public website without adopting and implementing policies and procedures reasonably designed to ensure any hypothetical performance is relevant to the likely financial situation and investment objectives of the intended audience.

Registered investment advisers are encouraged to review their Marketing Rule policies and procedures in light of these enforcements and the new Risk Alert.