Does Private Equity Have an Insider Trading Problem?
“Selective disclosure” is on the SEC’s radar, legal experts say.
Private equity deals with a ton of information, and depending on who you are, you get to see all of it, some of it, or none of it.
In public markets, rules governing disclosure abound, mitigating the prospect of selective disclosure—revealing actionable intelligence to certain investors but not others. Private equity has far less oversight, yet information asymmetry exists, and the Securities and Exchange Commission may ultimately consider it a problem that needs solving.
In 2000 the SEC adopted Regulation Fair Disclosure to restrict the widespread practice of company CEOs holding exclusive Q&A sessions with large shareholders. These investors would presumably gain deeper insight into the company’s performance and possibly an unfair trading edge over smaller investors.
The degree to which selective disclosure in private equity is unfair or harmful is debatable. But a growing number of legal experts believe the SEC will take an interest in PE’s version of selective disclosure because it is part of a broader concern —the unequal treatment of limited partners.
In many areas, private equity GPs have played favorites. It happens at the outset of a fund, when different terms and conditions are offered to different LPs based on size of commitment. It happens in the course of a co-investment when allocations are offered to strategic non-LPs, instead of to smaller current LPs with an appetite for direct exposure.
Here are some specific examples of favoritism:
- LPs are selected to make up the Limited Partner Advisory Committee (LPAC), which holds sessions with the GP. An LP serving on this committee, typically chosen because of the size of their commitment to a fund, will naturally gain access to information that is not shared with the others.
- Many LPs are granted side letters allowing for customized supplemental reporting. This often means that the LP receives fund information more frequently and in a custom format. It can also mean that the LP receives additional information not shared with the rest of the investor base.
- LPs frequently join the GP in co-investing, which often means gaining extraordinary access to the inner workings of the firm’s underwriting process and to the due diligence materials of the deal under review. If the deal goes through, the co-investing LPs have a great deal of information about the thesis and projections around the deal. Even if it doesn’t happen, the LP has gained valuable insight about how the firm really works.
Does any of this inequality matter? An LP armed with additional information about the fund can’t exactly trade on the information as they could with a public security. In theory, the LP would have an edge as a buyer or seller of fund interests on the secondary market, but these “trades” take considerable time to close.
An LP with sustained, superior access to a fund’s information would presumably be better able to decide whether or not to re-up to the next fund, or back a spin-out team. But, here again, the ability to monetize superior insights takes so much time that it becomes hard to measure the value of the “inside” information.
Ultimately, the appearance of impropriety may be enough. While it may be harmless to, say, regularly provide leverage-level information to a big, important LP but not to a smaller one, or to reveal partner economics to an important gatekeeper but not to other LPs, such asymmetries can create a suspicion of unfairness that can make investors, and the SEC, think there may be further inequalities worth looking into.
A growing number of legal experts believe the SEC will take an interest in PE’s version of selective disclosure because it is part of a broader concern —the unequal treatment of LPs.