March 9, 2022 - As we previously discussed (here and here), the SEC’s proposed Private Fund Disclosure Rule (“the proposed rule”) could seriously impact CLOs.

In the Economic Analysis section, the SEC discusses the costs and benefits of its many new requirements under the proposed rule. Today we focus on annual fund audits. The proposed rule states that a fund advised by a registered investment adviser must undergo an annual financial statement audit in accordance with GAAP (or substantially similar if a foreign private fund) by an independent public accountant subject to inspection by PCAOB. Who are these funds that will need a new audit process? On p. 210, the SEC lays out a table demonstrating that, while many hedge and private equity funds already undergo a financial statement audit, only 15% of “securitized asset funds” do so.  (For good reason, but that’s for another day.)

Jump forward to p. 249, and the cost benefit analysis of annual financial statement audits begins.  The SEC notes that the “benefit to investors in securitized asset funds may be relatively greater from the proposal, given the relatively lower frequency with which securitized asset funds currently undergo financial statement audits (p. 251).” The SEC-enumerated benefits include that investors would receive more reliable information, the audit would provide a check on the adviser’s valuation of private fund assets (and thus detect valuation irregularities and limit opportunity for over-valuation by adviser), test other assertions associated with the portfolio, and may provide a check against adviser misrepresentation of performance, fees and other information about the fund. (We’ll discuss why this doesn’t fit in the CLO context in a later post.)

The SEC goes on to state (a contention we disagree with) that with greater confidence in the information and fees paid to advisers, “investors may be more likely to invest in private funds and participate in resulting returns.”  In addition, the auditor inspection by PCAOB will improve the quality of the audit and financial reporting. A requirement for the auditor to report to the SEC in certain conditions can lead to enhanced regulatory oversight, which would benefit investors and also allow the SEC to allocate its examinations resources more efficiently. “Anticipating this, advisers would have stronger incentives to avoid such harmful activities.”

There are non-trivial costs to secure these changes. The SEC estimated that a typical annual fund audit costs $60,000. Therefore, the estimated cost for all registered advisers getting annual audits for all private funds (at $60,000 per audit) would come to $2.270 billion (with a “b”). It would also take approximately 92,479.32 internal hours of work at a cost of approximately $27.6 million. Importantly, nearly all private funds except securitized asset funds already do annual audits. Therefore, any cost increase may be mostly borne by securitized asset funds. We quote the SEC in its entirety below.  

“For example, all or a portion of the costs described in this section may be disproportionately borne by advisers or investors (or both) to securitized asset funds, given that fewer securitized asset funds currently undergo financial statement audits than other categories of funds. We believe that the costs incurred may approximate 10% of these amounts, because across all types of funds, approximately 90% of funds are currently audited in connection with the fund adviser’s alternative compliance under the custody rule. However, because a large portion of funds who do not currently undergo financial statement audits are securitized asset funds, to the extent that audits for securitized asset funds are more costly than for other fund types (for example, if it is more burdensome to audit financial statements that primarily contain securitized assets), then the costs of the proposal may be greater than 10% of the amounts described above (emphasis added).”

The low end of the SEC estimate (10% of $2.75 billion) presumably means that the SEC estimates an cost of at least a $275 million for annual audits for securitized asset funds.

The LSTA continues to analyze the SEC’s extensive proposed Private Fund Disclosure Rule. Comments currently are due on April 11th. The LSTA, along with a number of other trade associations, have requested an extension – but are attempting to meet the SEC’s aggressive timeline.

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