How the SEC’s Proposed Rules on Fairness Opinions Affect Private Fund Advisers

March 2022

BY

Alex ClintonManaging Director, Valuation & Capital Market Analysis

In early February, the SEC released new proposed rules that, if implemented, would have an expansive impact on private fund advisers, especially those who operate in the adviser-led secondaries market. The proposed reforms signal the SEC’s intention to enhance regulation over a part of capital markets that has seen increased activity among investors and advisers. In particular, the proposal would make it mandatory for advisers to obtain a fairness opinion for adviser-led secondary transactions. Accordingly, it is critical for advisers to understand the proposed requirements and potential benefits of this change.
 

Proposed Reforms

The proposed rules fall under the Investment Advisers Act of 1940 and would implement new reporting and compliance requirements in the name of investor protection. As noted in the SEC’s related fact sheet, private funds hold more than $18 trillion of gross assets, including those of large pension plans and university endowments. Private funds have traditionally been reserved for sophisticated investors and lack the transparency and oversight associated with public funds. Because these funds have a significant role in financial markets and affect so many people, the SEC seeks to increase clarity and protection for investors through the newly proposed regulations.

The proposal embodies several distinct elements that would impact private fund advisers and require updated compliance programs around the following areas:
  • Providing standardized quarterly statement of fees and fund performance disclosures to investors.
  • Obtaining an external financial statement audit.
  • Obtaining a fairness opinion in connection with an adviser-led secondary transaction.
  • For some funds, refraining from certain prohibited activities (i.e., reducing adviser clawbacks for taxes) and providing certain preferential treatment to investors.
  • Establishing new processes to make and keep a record of an annual review of the program’s implementation and effectiveness.

 

Proposed Reforms Increase the Importance of Fairness Opinions for Adviser-Led Deals

The proposed adviser-led secondaries rule would prohibit an adviser from completing an adviser-led secondary transaction with respect to any private fund, unless, prior to the closing of the transaction, the adviser distributes a fairness opinion from an independent opinion provider to investors in the private fund. Additionally, the adviser must provide a summary of any material business relationships the adviser or any of its related persons has, or has had within the past two years, with the independent opinion provider. Therefore, a key element for adviser-led secondary transactions is the proposed requirement for advisers to obtain a fairness opinion from an independent opinion provider. Even without a requirement by the SEC, fairness opinions offer a way for advisers to address certain conflicts of interest and are considered best practice for adviser-led secondaries.

The SEC’s proposal defines an adviser-led secondary transaction as any transaction initiated by the investment adviser, or any of its related persons, that offers private fund investors the choice to: “(1) sell all or a portion of their interests in the private fund; or (2) convert or exchange all or a portion of their interests in the private fund for interests in another vehicle advised by the adviser or any of its related persons.”

In the eyes of the SEC, a fairness opinion would offer “an important check against an adviser’s conflicts of interest in structuring and leading a transaction from which it may stand to profit at the expense of the investors.” Overall, the proposal aims to enhance investor protections and transparency, and fairness opinions can play an important role in achieving that. While many private fund advisers already use fairness opinions, it is not currently required for adviser-led secondary transactions.

Should the proposed SEC rules be implemented, this requirement would lead advisers to seek out fairness opinion providers and/or experienced valuation professionals to assist with the financial instruments, transactions and restructurings that make up secondary deals.

To mitigate an adviser’s potential conflict of interest, the rule would require opinions to be issued only by an independent opinion provider, which the SEC defines as “an entity that provides fairness opinions in the ordinary course of its business and is not a related person of the adviser.” The “ordinary course of business” aspect of the definition mainly corresponds to those persons or firms “with the expertise to value illiquid and esoteric assets based on relevant criteria.”

 

The Benefits of Working with Experienced Valuation Professionals

A fairness opinion from professionals with technical knowledge and industry experience helps contribute to investor confidence. While the SEC’s proposal remains pending, there are benefits to taking a proactive approach on compliance and seeking a fairness opinion for all adviser-led secondary transactions.

As the proposed rule notes, fairness opinions may reduce risk for investors by identifying mispriced secondary-led transactions. If investors anticipate lower risk of harm from incorrectly priced transactions, investor participation may increase resulting in closer alignment of investor choices and preferences regarding private fund terms, investment strategies and investment outcomes.

Based on objective, independent analyses, these fairness opinions can help private fund advisers address the SEC’s concerns expressed in these latest proposed rulings, particularly regarding potential conflicts of interest and information disparities. As regulatory scrutiny of the private funds market increases, taking steps toward greater transparency and investor protection benefits investors and advisers alike.

BDO’s extensive industry, tax, accounting and financial knowledge are brought to bear in high-quality fairness opinions through the Valuation & Capital Market Analysis (VCMA) practice. The VCMA practice regularly supports transactions through both valuation and fairness opinion services for public and private transactions, sales or mergers, going-private transactions, and financing transactions that may dilute current investors (e.g., debt/equity swaps).

Contact BDO’s Valuation & Capital Market Analysis practice to learn more about how they can help you understand the SEC’s proposed reforms and the multiple benefits of obtaining a fairness opinion.