Watered-down SEC fund disclosure changes still worth paying attention to

Venture capital firms have some disclosing to do.

On August 23, the SEC passed a handful of new fund disclosure rules concerning clawbacks, preferential treatment of LPs and fees.

Fund managers might not have paid much attention to this, though; the rules that the SEC passed were a watered-down version of the initial proposals, including the removal of a potential rule change that VCs seemed most worried about regarding fiduciary duty. But there are still a few things that VCs should pay attention to — especially emerging managers.

The changes to the rules, while not drastic, have the potential to make fundraising more difficult for VCs. Also, punishment for not following the rules correctly will fall on GPs themselves; they can’t turn to their LPs for financial help anymore.

“My initial thoughts on this were, it’s like trying to learn a new dance,” Chris Harvey, an emerging fund lawyer at Harvey Esquire APC, told TechCrunch+. “Everyone is doing the waltz, [but now] we are getting rid of the waltz, and we are moving to a new style. There will be some toe stepping, and not everyone will be on the beat.”

The treatment of LPs

There are two key rule changes for VCs to consider.

First, there’s new language regarding preferential treatment. The new fund disclosure rules require firms to disclose any preferential treatment of an LP that could have material or negative impact on the other LPs involved in the fund. This could include giving an investor a different capital call structure, different rights to co-investments or different fees.

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Firms would have to disclose this preferential treatment to any prospective LPs in addition to an annual written notice to all existing LPs.

Harvey said that other LPs having different terms won’t bother some smaller investors — for example, investors who might have assumed they were getting less generous terms based on their check size compared to larger backers — but it could definitely have an impact, especially when it comes to certain types of institutional LPs. Investors like banks and endowments often require certain special language and treatment when they back a fund.

Funds will now have to decide how to approach certain potential perks that could make an actual difference regarding whether LPs are willing to invest. LPs, on the other hand, will have to decide how to navigate the rule changes without putting themselves in a position where they have to justify why they should have certain rights over other investors.

“My philosophy is always to try to smooth out those sharper requests,” Harvey said. “Everyone gets a right to co-invest. Everyone has the ability to invest, but not everyone is going to get pro rata rights. Does every LP get that, or do we put in a side letter?”

Larger firms have an easier way of working around the issue, as the disclosure rule language seems to imply that if a firm were to raise a fund through separate parallel vehicles — a common practice for funds of substantial size — they could skirt around disclosing everything to all of their prospective LPs, rather than just those in that specific vehicle.

But for those who aren’t likely to raise their next fund in that format, like emerging managers, this change could make fundraising just that much more difficult. Ty Findley, the co-founder and general partner at Ironspring Ventures, which is currently raising a $100 million second fund, pointed out that LPs consider backing these nascent managers as being inherently more risky, and if they aren’t able to change the terms to make it seem more worth it for them to participate, they may pass entirely.

This dynamic could make it more difficult for emerging managers to land an anchor investor who they may have been okay with giving preferential treatment — since landing that critical commitment makes the rest of the fundraising process easier. Now emerging managers will have to find a balance in what they are willing to give and disclose that will land the LP they want without preventing other LPs from being uninterested without the same treatment.

The treatment of GPs

The other key aspect of these rule changes is what happens when a GP gets caught violating any of the new disclosure changes, whether intentionally or not. Under the new rules, GPs are restricted from passing on fees or expenses — related to an investigation or resulting sanction imposed by the SEC — to their LPs.

“If you the GP are charged with, or even found guilty up to a certain point, and you get sanctioned for that activity, you cannot ask your LPs to get reimbursed,” Harvey said. “You can’t get their waiver, you can’t even disclose it, it doesn’t matter.”

This could also be more of an issue for emerging managers, because if they are caught, they may be on the hook for money the firm doesn’t have — for example, if they haven’t started seeing exits or earning distributions yet.

But Harvey said these changes to disclosures aren’t going to be particularly pricy for firms to keep up with; it’s estimated at $11,000 a year. If firms simply decide to disclose everything, even if it makes fundraising more difficult or causes some hard conversations with LPs, they should be relatively easy to comply with. VCs just have to make sure they are covering their bases.