The Securities and Exchange Commission has finalized rules that will overhaul how the $27 trillion private fund industry—including private equity, hedge funds and venture capital funds—deals with investors. Last week six trade groups sued the SEC seeking to block the regulations.
Private funds had been largely off-limits for the SEC because only high-net-worth individuals and large institutional investors can invest in them and these sophisticated investors can protect themselves. The new rule will upend that 90-year status quo—and it is only the beginning of the commission’s attack on private markets.
Fees and investment terms between private funds and their investors have always been freely negotiated. In practice, that means the largest investors, including defined-benefit pension plans that invest on behalf of firefighters, teachers and police officers, often got the best deal. The new SEC rule will require that certain fee arrangements be “fair and equitable” and ban private funds from offering their largest investors the opportunity to cash in early. In practice, this will mean that defined-benefit plans will pay higher fees and have less liquidity, ultimately harming retirees.
The final rule will also establish quarterly disclosure requirements for fees and performance as well as an annual audit requirement to second-guess the valuation of fund investments. These compliance costs will be borne by all investors in the form of higher fees and lower returns.
The SEC’s rationale for its new rule is that private fund markets are uncompetitive. That’s simply wrong. Fees are going down and the largest funds, like Citadel and Blackstone, hold small market shares. The five biggest hedge funds constitute less than 5% of total assets under management. Performance net-of-fees has been strong. Private equity funds have returned 12% a year since 1989, compared with 8% for the S&P 500.
The private companies in which private equity funds invest are also booming. U.S. companies now raise almost four times as much capital each year in private markets than from public offerings. Large companies no longer need to go public to raise capital, as there are a record 700-plus unicorns—private companies with billion-dollar valuations—including SpaceX and Stripe. A prime reason for this success is that private equity owners manage their businesses directly, while public companies have to rely on boards to represent a dispersed shareholder base.
The story for U.S. public companies is much bleaker. There are about half as many today as in the 1990s, and the regulatory cost of being a public company has never been higher. The U.S. share of global initial public offerings is also at a historic low, close to 10%, meaning that foreign companies are no longer attracted to America’s public markets.
The SEC’s new private funds rule is only the beginning. The SEC realizes that public markets are shrinking and private markets are growing. To protect public markets from shrinking further, it has scheduled in its fall regulatory agenda a full frontal attack on private markets.
A broker who holds shares in a private company on behalf of clients, or a fund that invests in one, counts as only one shareholder in the company. The SEC intends to look through brokers and funds so that each client or investor would count as a shareholder. This would mean many private companies would exceed the maximum of 2,000 shareholders for a private company and have to register as a public company. And the SEC intends to require all other private companies to make public filings on their financial statements for the first time.
The Federal Trade Commission under Lina Khan is also honing its regulatory sights on private equity. The FTC has said it will consider blocking more private equity investments on the basis that such investments may increase market concentration. This ignores evidence that private equity funds enhance competition in markets where their portfolio companies operate.
Many academics, former government officials and legal experts have argued that the SEC and the FTC lack the statutory authority to target private markets in this way. The SEC’s rule attempts to establish a new regulatory regime for private funds based on provisions of the Investment Advisers Act of 1940 and Dodd-Frank Act that don’t mention private funds and have never been used for this purpose. That falls foul of West Virginia v. EPA (2022), in which the Supreme Court held that federal agencies need specific authorization from Congress before issuing regulations that deal with “major questions.” The SEC’s private-funds rule also fails to satisfy cost-benefit analysis required under law, ignoring evidence that it will negatively affect markets and jobs. Thus the commission’s actions are vulnerable to court challenge.
The SEC’s aggressive approach to regulating private markets reflects the real theory of Bidenomics—the notion that the government knows better than the market. If the administration’s attack succeeds, private markets will go the way of public ones, leaving the economy starved for capital.
