A Deeper Look into the SEC Private Fund Rules – Quarterly Statements and Private Fund Audit Requirements

The increasing number of private funds and advisers has led to a rise in practices that pose risks and harm to investors. The majority of private fund advisers are registered with or report to the SEC as exempt reporting advisers. In response, the SEC has adopted new rules and amendments under the Advisers Act to protect investor interests by increasing transparency, competition, and efficiency in the private funds market. These regulatory changes, known as the “Final Rules,” were issued on August 23, 2023, marking a significant milestone in reshaping the regulatory framework for private fund advisers since the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) was enacted over a decade ago. This article will take a deeper dive into the Quarterly Statements Rule and the Private Fund Audit Rule, which are expected to have a significant impact on Registered Investment Advisers of private funds.

Summary of the Final Rules

All private fund advisers registered with the SEC must comply with the (1) Quarterly Statement Rule, (2) Private Fund Audit Rule, and (3) Adviser-Led Secondaries Rule, and regardless of registration status with the SEC, all private fund advisers must comply with the (4) Restricted Activities Rule and (5) Preferential Treatment Rule. Additionally, the Final Rules amend the books and records rule under section 204-2 of the Advisers Act (the “books and records rule”) to facilitate the SEC’s ability to assess these advisers’ compliance with the Final Rules and similarly enhance an adviser’s compliance efforts as a result.

Intending to reduce the burden and costs associated with having to renegotiate contractual agreements between advisers and investors, the SEC has provided legacy status provisions for certain aspects of the Restricted Activities Rule and Preferential Treatment Rule if they relate to “governing agreements that were entered into before the compliance date if the rule would require the parties to amend such an agreement” and relate to funds that “commenced operations as of the compliance date.” For the Restricted Activities Rule, the SEC has provided legacy status for aspects that link to investor consent, which restricts an adviser from borrowing from a private fund and charging certain investigation fees and expenses. For the Preferential Treatment Rule, the SEC has provided legacy status under the prohibitions aspect, which prohibits advisers from providing certain preferential redemption rights and information about portfolio holdings. Legacy status has not been provided in the disclosure portions of these rules. The SEC believes that transparency of preferential treatment terms and transparency into these practices is essential and will not harm investors in private funds.

Transition Period

A summary of compliance dates is as follows:

* Large Private Fund Advisers are advisers with $1.5 billion or more in private funds assets under management, and Small Private Fund Advisers are advisers with less than $1.5 billion in private funds assets under management.

** The Final Rules were published in the Federal Register on September 14, 2023.

*** The SEC is amending Rule 206(4)-7 under the Advisers Act to require all advisers to “document the annual review of their compliance policies and procedures in writing.” The amendment is meant to assist the SEC in ensuring that the advisers assess, at least annually, whether they have considered any compliance matters that arose during the previous year, any changes to their business activity, and any rules and regulations that may result in a shift in their policies and procedures.

Quarterly Statements Rule

Final Rule 211(h)(1)-2 requires all private fund advisers who are registered (or required to be registered) with the SEC to prepare and distribute quarterly statements to their investors. The quarterly statement will provide investors with fee and expense disclosures for the prior quarter or, in the case of a newly formed private fund initial account statement, its first two full fiscal quarters of operating results. It will also provide investors with certain performance information depending on whether the fund is categorized as a liquid fund or an illiquid fund. The intention of the quarterly statement is to allow a private fund investor to compare standardized cost and performance information across its private fund investments to assist investors in making informed investment decisions, including whether to remain invested in certain private funds or to invest in other private funds managed by the adviser. The SEC also believes this will decrease the likelihood that investors will be defrauded, deceived, or manipulated because they will be better positioned to monitor the adviser and their respective investments. It also increases the probability that any such misconduct will be detected sooner. The rule requires quarterly statements to be distributed to investors within 45 days (75 days for fund of funds) after the first three fiscal quarters end and within 90 days (120 days for fund of funds) after the end of each fiscal year.

The quarterly statement must use language that is clear, concise, and organized. It must be presented in a format that facilitates a review from one quarterly statement to the next. In addition, if doing so would provide more meaningful information to the private fund’s investors, the adviser must consolidate the reporting to cover similar pools of assets. Finally, for the quarterly statement to comply with the Final Rules, it must include the following:

1. a table for the private fund that discloses, at a minimum, the following information:
   1. a detailed accounting of all compensation, fees, and other amounts allocated or paid to the investment adviser or any of its related persons⁽¹⁾ by the private fund during the reporting period with separate line items for each category of allocation or payment reflecting the total dollar amount, including, but not limited to, management, advisory, sub-advisory, or similar fees or payments, and performance-based compensation⁽²⁾,
   2. a detailed accounting of all fees and expenses allocated to or paid by the private fund during the reporting period (other than those listed in #1 above), with separate line items for each category of fee or expense reflecting the total dollar amount, including, but not limited to, organizational, accounting, legal, administration, audit, tax, due diligence, and travel fees and expenses, and
   3. the amount of any offsets or rebates carried forward during the reporting period to subsequent periods to reduce future payments or allocations to the adviser or its related persons.⁽¹⁾
2. a table for the private fund that discloses, at a minimum, the following information for each covered portfolio investment⁽⁴⁾:
   1. a detailed accounting of all portfolio investment compensation⁽³⁾ allocated or paid to the investment adviser or any of its related persons⁽¹⁾ by the covered portfolio investment⁽⁵⁾ during the reporting period, with
   2. separate line items for each category of allocation or payment reflecting the total dollar amount and
   3. presented both before and after the application of any offsets, rebates, or waivers.
3. prominent disclosure regarding how all expenses, payments, allocations, rebates, waivers, and offsets are calculated and include cross-references to the sections of the private fund’s organizational and offering documents that set forth the applicable calculation methodology.
4. the adviser must determine if the private fund is an illiquid fund or a liquid fund. This determination must occur no later than the time the adviser sends the initial quarterly statement.
   1. for a liquid fund:
      1. annual net total returns for each fiscal year over the past ten fiscal years or since inception, whichever period is shorter,
      2. average annual net total returns over the one-, five-, and 10-fiscal-year periods, and
      3. the cumulative net total return for the current fiscal year as of the end of the most recent fiscal quarter covered by the quarterly statement.
   2. for an illiquid fund:
      1. The following performance measures, shown since the inception of the illiquid fund through the end of the quarter, covered by the quarterly statement (or, to the extent quarter-end numbers are not available at the time the adviser distributes the quarterly statement, through the most recent practicable date) and computed with and without the impact of any fund-level subscription facilities⁽⁶⁾:
         1. gross IRR⁽⁷⁾ and gross MOIC⁽⁸⁾ for the illiquid fund,
         2. net IRR⁽⁹⁾ and net MOIC⁽¹⁰⁾ for the illiquid fund, and
         3. gross IRR⁽⁷⁾ and gross MOIC⁽⁸⁾ for the realized and unrealized portions of the illiquid fund’s portfolio, with the realized and unrealized performance shown separately.
5. a statement of all capital inflows the private fund has received from investors and all capital outflows the private fund has distributed to investors since the private fund’s inception, with the value and date of each inflow and outflow for the illiquid fund.
6. the date as of which the performance information is current and a prominent disclosure of the criteria used and assumptions made in calculating the performance.

Amendments were made to the books and records rule requiring advisers to private funds to retain information related to the Quarterly Statements rule that includes the following:

1. a copy of any quarterly statement distributed to fund investors along with a record of each addressee and the corresponding date(s) sent,
2. all records evidencing the calculation method for all expenses, payments, allocations, rebates, offsets, waivers, and performance listed on any quarterly statement distributed and
3. documentation substantiating the adviser’s determination that the private fund it manages is a liquid fund or an illiquid fund.

Definitions included in the Final Rules for Quarterly Statements

(1) Related persons means:
– All officers, partners, or directors (or any person performing similar functions) of the adviser;
– All persons directly or indirectly controlling or controlled by the adviser;
– All current employees (other than employees performing only clerical, administrative, support, or similar functions) of the adviser and
– Any person under common control with the adviser.

(2) Performance-based compensation means allocations, payments, or distributions of capital based on the private fund’s (or any of its investments’) capital gains, capital appreciation, or other profit.

(3) Portfolio investment compensation means any compensation, fees, and other amounts allocated or paid to the investment adviser or any of its related persons⁽¹⁾ by the portfolio investment⁽⁴⁾ attributable to the private fund’s interest in such portfolio investment⁽⁴⁾, including, but not limited to, origination, management, consulting, monitoring, servicing, transaction, administrative, advisory, closing, disposition, directors, trustees or similar fees or payments.

(4) Portfolio investment means any entity or issuer in which the private fund has directly or indirectly invested.

(5) Covered portfolio investment means a portfolio investment⁽⁴⁾ that allocated or paid the investment adviser or its related persons⁽¹⁾ portfolio investment compensation⁽³⁾ during the reporting period.

(6) Fund-level subscription facilities means any subscription facilities, subscription line financing, capital call facilities, capital commitment facilities, bridge lines, or other indebtedness incurred by the private fund that is secured by the unfunded capital commitments of the private fund’s investors.

(7) Gross IRR means an internal rate of return⁽¹¹⁾ that is calculated gross of all fees, expenses, and performance-based compensation⁽²⁾ borne by the private fund.

(8) Gross MOIC means a multiple of invested capital⁽¹²⁾ that is calculated gross of all fees, expenses, and performance-based compensation⁽²⁾ borne by the private fund.

(9) Net IRR means an internal rate of return⁽¹¹⁾ that is calculated net of all fees, expenses, and performance-based compensation⁽²⁾ borne by the private fund.

(10) Net MOIC means a multiple of invested capital⁽¹²⁾ that is calculated net of all fees, expenses, and performance-based compensation⁽²⁾ borne by the private fund.

(11) Internal rate of return means the discount rate that causes the net present value of all cash flows throughout the life of the fund to be equal to zero.

(12) Multiple of invested capital means, as of the end of the applicable fiscal quarter, the sum of the unrealized value of the illiquid fund and the value of all distributions made by the illiquid fund divided by the total capital contributed to the illiquid fund by its investors.

Private Fund Audit Rule

Final Rule 206(4)-10 requires all private fund advisers who are registered (or required to be registered) with the SEC to obtain an annual financial statement audit for each of the private funds they advise (other than a securitized asset fund⁽¹³⁾), directly or indirectly. In addition, for a private fund that the adviser does not control⁽¹⁴⁾, the adviser is prohibited from providing investment advice, directly or indirectly, to the private fund if the adviser fails to take all reasonable steps to cause the private fund to undergo a financial statement audit that meets the requirements of the rule, if the private fund does not otherwise undergo such an audit. The SEC believes that not only will this rule protect the fund and its investors against the misappropriation of fund assets, but it will also provide an important check on the adviser’s valuation of private fund assets, especially in cases where it serves as the basis for the calculation of the adviser’s fees and creates a conflict of interest between the adviser and private fund investors.

Although the Private Fund Audit rule effectively eliminates the surprise examination option under the Custody Rule for private fund advisers and increases costs to investors, the SEC believes that the requirements of this rule are justified as an audited financial statement provides critical information to investors that a surprise examination does not. An audit not only provides comfort on the existence assertion of the pooled investment vehicles’ investments, similar to a surprise examination, it also provides comfort on the valuation, presentation and disclosure, rights and obligations, and accuracy assertions. In addition, through the additional disclosure requirements included in an audit (i.e., disclosures including fair value measurements and leveling tables, a description of the valuation techniques and inputs used in the fair value measurement of the fund’s investments, material related party transactions, and fund borrowings, such as margin borrowings or fund-level subscription facilities⁽⁶⁾) investors can more effectively monitor their investments and make informed decisions regarding where to invest their money.

In order to comply with the Private Fund Audit rule, the annual financial statement audit must include the following:

1. the audit must be performed by an independent public accountant that meets the standards of independence described in rule 2-01(b) and (c) of Regulation SX, that is registered with and subject to regular inspections by the Public Company Accounting Oversight Board (“PCAOB”). Under the current Custody Rule, advisers to pooled investment vehicles qualifying for the audit provision must meet the standards of independence described in Regulation S-X as opposed to the American Institute of Certified Public Accountants (“AICPA”) standards of Independence. According to the SEC, the independence standards described in Regulation S-X focus on those relationships or services, including certain non-audit services, that are more likely to threaten an auditor’s objectivity or impartiality.
2. the audited financial statements must be prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) or some other comprehensive body of accounting standards similar to U.S. GAAP if the differences are reconciled to U.S. GAAP as currently required under the custody rule.
3. the annual audited financial statements must be delivered to investors within 120 days of the private fund’s fiscal year-end and promptly upon liquidation. This requirement is consistent with current practices of private fund advisers that obtain an audit to comply with the Custody Rule under the Advisers Act and will provide investors with uniformity in the information they receive.

Amendments were made to the books and records rule requiring advisers to private funds to retain information related to the Private Fund Audit rule that includes the following:

1. a copy of any audited financial statements prepared and distributed along with a record of each addressee and the corresponding date(s) sent (the rule does not require private fund advisers to make and retain records of the addresses and delivery methods used to disseminate audited financial statements),
2. a record documenting steps taken by the adviser to cause a private fund client, with which it is not in a control relationship with, to undergo a financial statement audit that complies with the rule.

Definitions Included in the Final Rules for the Private Fund Audit Rule

(13) Securitized asset fund is any private fund whose primary purpose is to issue asset-backed securities and whose investors are primarily debt holders.

(14) Control means the power, directly or indirectly, to direct the management or policies of a person, whether through ownership of securities, by contract, or otherwise. For the purposes of this definition, control includes:

• Each of an investment adviser’s officers, partners, or directors exercising executive responsibility (or persons having similar status or functions) is presumed to control the investment adviser;
• A person is presumed to control a partnership if the person has the right to receive upon dissolution or has contributed 25 percent or more of the capital of the partnership;
• A person is presumed to control a limited liability company if the person:
  • Directly or indirectly has the right to vote 25 percent or more of a class of the interests of the limited liability company;
  • Has the right to receive upon dissolution, or has contributed, 25 percent or more of the capital of the limited liability company; or
  • Is an elected manager of the limited liability company;
• A person is presumed to control a trust if the person is a trustee or managing agent of the trust.

Going Forward

Due to the SEC’s issuance of the Final Rules on August 23, 2023, which were published in the Federal Register on September 14, 2023, private fund advisers now find themselves up against the clock with not only assessing how these rules will impact their operations but also determining the best path forward, both for themselves and their investors. The costs of issuing quarterly statements, undergoing financial statement audits, revising agreements, updating, and implementing policies and procedures, and seeking advice from legal counsel where necessary may prove costly for certain smaller advisers. The SEC believes, however, that the end result will provide an opportunity for both advisers and investors to strengthen their relationships with one another. On the one hand, advisers will be held more accountable for the investments they make and the fees they charge. On the other hand, investors will be provided with increased protection and greater transparency into the adviser’s investment landscape, enabling them to make better investment decisions. The road ahead will undoubtedly have its challenges, but the ultimate goal is to create a more secure environment for investors with increased transparency while promoting efficiency, competition, and capital formation in the private funds market.

Sources

1. https://www.sec.gov/files/ia-6383-fact-sheet.pdf
2. https://www.sec.gov/files/rules/final/2023/ia-6383.pdf
3. https://www.marcumllp.com/insights/adoption-of-new-rules-for-private-fund-advisers