Private Markets: Governance Issues Rise to the Fore

Private markets’ meteoric growth since the Great Financial Crisis has impacted financial markets and the real economy and may carry potential risks for investor protection and financial stability. Responding to this growth, regulators globally have turned their attention to private markets with heightened interest, even urgency. In the United States, which has a dominant share of private market investments, the courts recently struck down sweeping and controversial new rules for private fund advisers that were adopted by the securities regulator.

Private markets are very much in the news. “Private Markets: Governance Issues Rise to the Fore” was written before a 5 June 2024 court ruling in the United States that struck down a far-ranging new set of rules on private fund advisers. But the matter is far from closed. Rather, we expect continued debate on what is optimal in terms of the regulation and governance of private markets, not only in the United States but also in markets around the world. Indeed, the absence of stringent regulations makes industry best practices and self-governance—including relations between LPs (investors) and GPs (managers)—all the more important. Those are the issues that we examine in this report. Please see Appendix 3 in the report: “Dueling Court Briefs: The SEC’s Private Fund Adviser Rules,” in which we summarize the opposing positions placed before the court. The court’s ruling can be found here.

Despite increased scrutiny, however, there remains a dearth of public information on how private markets function, which may help explain the wide divergence of views on private markets. Advocates of private markets applaud their growth and efficiency, lauding them as examples of successful private ordering where markets operate optimally without substantial external interference. Not so, critics argue. They contend that private markets require regulatory intervention to address shortcomings that private players have been unable to resolve on their own. These shortcomings are largely related to private markets’ governance structure and how they manage potential conflicts of interest.

“Private Markets: Governance Issues Rise to the Fore” aims to provide a comprehensive and unbiased understanding of private markets, highlighting governance issues and regulatory considerations. Through a combination of a primer and findings from a global survey of CFA Institute members, it seeks to contribute to public knowledge and inform stakeholders involved in these markets.

The rise of inflation and interest rates have jolted private markets into a new era. Governance issues and questions of private ordering have come to the fore in this new environment. The issues revolve around relationships between the limited partners (LPs), which invest in private markets, and the general partners (GPs), which are the firms that sponsor and manage private market funds. Key questions about private markets include whether institutional investors can effectively safeguard their interests in negotiations with GPs despite information asymmetries or whether, on the contrary, fund managers hold disproportionate power.

This report focuses on illiquid private funds, including private equity, credit, venture capital, real estate, and infrastructure funds. Its objective is neither to endorse nor censure private markets but to offer a neutral understanding beneficial to investment professionals, policymakers, and other stakeholders interested in financial markets. CFA Institute represents all investment professionals.

The report delves into critical issues within private markets that include the following:

• Multilayered conflicts of interest—between GPs and LPs, between large and small LPs, and within some institutional LPs themselves
• LP–GP relations
• Opacity
• Valuation
• Fees and expenses
• Regulatory focus

CFA Institute Global Membership Survey
In October 2023, CFA Institute conducted a global survey of investment professionals to gather their views and practices regarding private markets. The survey represented all members, including those with experience in LPs and GPs. Unlike a number of other surveys, ours focuses on fundamental governance issues rather than market outlook.

Most respondents expressed a moderate point of view in assessing private market problems and the need for further regulation. A slight majority (51%) said that private market practices can be improved, but the problems are not significant. A similar majority (52%) supported new regulations—but only limited measures. Respondents generally favored required disclosures (or disclosure and consent) rather than outright prohibitions. Turning to specific regulations, substantial majorities favored requirements for GPs to provide annual audits (79%), quarterly statements (70%), and a fairness or valuation opinion of any adviser-led secondary transaction (61%).

Based on the survey’s findings, this report offers the following recommendations for investors and policymakers.

For Investors:

1. As with any investment, perform due diligence and do not allow the fear of missing out to drive your decision.
2. Coordinate between your institution’s investment and legal teams and give the latter adequate time to conduct a meaningful legal review before committing to a fund.
3. Gain adequate information and do not accept excessive informational asymmetries.
4. Be willing to walk away from a deal if the terms are too problematic.
5. Keep up vigilance after you sign on to the fund: An attitude of “set it and forget it” invites norms that fail to protect investors’ interests.
6. Address any potential internal agency conflicts within your institution.

For Policymakers:

1. Recognize that regulation has a legitimate role to play in private markets through establishing basic guardrails, even while allowing private actors to negotiate optimal terms.
2. Focus on transparency, conflicts of interest, fees and expenses, and valuations.
3. Preserve public market integrity; do not weaken investor protections in public markets in a misguided effort to attract more public companies.
4. Be cautious about retail access. If you allow it, consider requiring retail investments to go through professional intermediaries that have the size and expertise to overcome information asymmetries and risks of adverse selection in private markets.