Hi. It’s me. I’m back. And this newsletter is back.
We took a half-year hiatus, so I could have a baby and spend some time with her.
When you have a baby – as many of our readers know – there’s a minimum standard of care. You feed the baby. You clothe the baby. You give the baby a safe, temperate place to sleep. Parents typically don’t approach their roles with much risk tolerance because, well, babies are quite fragile. Sure, accidents happen (I once dropped a cell phone on her head while trying to FaceTime with doting grandparents. Other than a small bruise, she’s fine). But the bar for risk is high. I don’t take her on motorcycles or bungee jumping. She’s a baby.
But parents’ standards of care change as babies grow older. Teenagers get more responsibility than kindergarteners.
Similarly, the fiduciary duty is different when caring for the investments of those who have money to lose (“sophisticated investors”) and those who don’t (“retail investors”).
Those in the “sophisticated” camp tend to pay managers more to take on risk because of the prospect of outsized returns. That’s why hedge funds and private equity funds, and especially venture capital funds exist. Without that tradeoff, everyone would be invested in Treasurys. But the risk doesn’t always lead to rewards. Sophisticated investors can – and often do – lose money.
Most of the time it ends there. But part of a sweeping change sought by the Securities and Exchange Commission would take fund managers’ culpability a step further if they don’t effectuate a greater standard of care.
The rule change involves lowering the bar for indemnification of fund managers to “ordinary negligence” from “gross negligence.” The latter, current standard, allows limited partners to sue general partners only for recklessness or disregard to obvious risk. But if that were changed to “ordinary negligence,” then LPs may be able to sue for simpler mistakes, making it easier for them to bring claims against GPs.
“It would monumentally change the relationship between fund managers and investors,” said Marc Elovitz, partner and chair of the regulatory practice at Schulte Roth & Zabel, in an interview for the Delivering Alpha Newsletter.
“The ability for fund managers to take risks and to be protected for their simple day to day conduct is fundamental to having an investment strategy that has potentially higher rewards, “ said Schulte’s Elovitz, whose law firm represents investment funds. “If you’re going to have funds that offer potentially higher returns, there are going to be risks associated with that. And investment managers are going to have a hard time protecting themselves from being on the hook for those risks.”
Even the Institutional Limited Partners Association, which has been a broad proponent of the rule changes, has raised concerns about the adverse effects stemming from a broad change in this standard.
“ILPA believes that an umbrella application of the ordinary negligence standard would have the unintended consequence of impacting a [general partner’s] risk tolerance and potentially damaging returns produced in private funds,” the group said in a recent analysis of the proposal.
However, ILPA said that, “an ordinary negligence standard as applied to breach of contract would assure meaningful progress.”
SEC Chair Gary Gensler has said in the past that this proposal prohibits private fund advisors from “engaging in a number of activities that are contrary to the public interest and the protection of investors,” including indemnification or limitation of its liability for certain activities. The SEC did not respond to our request to comment for this newsletter.
The Private Fund Advisers (PFA) rule, which was initially proposed in February 2022, covers a lot of ground, including quarterly fee and expense reporting and preferential treatment of certain LPs over others. The indemnity change is one piece of the reform. In a recent memo to clients, Several law firms have said they expect a final vote on the rule will take place this year.
If it passes in its current form, critics say the reforms would most certainly affect the risk tolerance among private funds, who would need to tread much more carefully in making investment decisions.
It’s kind of like taking your teenager to the amusement park but only riding the merry-go-round instead of the rollercoasters. And for many, that may not be worth the price of admission.
