Adoption of New Rules for Private Fund Advisers
On August 23, 2023, the U.S. Securities and Exchange Commission (SEC) ushered in a new era of regulatory oversight by adopting a series of rules and amendments under the Investment Advisers Act of 1940 (Advisers Act). These significant regulatory changes, collectively called the “Final Rules,” represent a pivotal response to the evolving regulatory landscape for private fund advisory services. In the pursuit of safeguarding the interests of investors, the SEC has identified three primary industry factors that can potentially expose investors to significant risks and harms. This recognition has driven the SEC to take decisive action by implementing these Final Rules, reshaping the regulatory framework governing private fund advisers, and underscoring their commitment to enhancing transparency and investor protection within the financial markets.
Lack of Transparency
The SEC cited a current lack of transparency in the industry as private fund advisers do not have specific requirements to provide investors with detailed information relating to the terms of the advisers’ relationships with funds and their investors. Examples provided by the SEC include the fact that there are no specific requirements for advisers to disclose detailed information on the funds’ investments, performance, or incurred fees and expenses to investors. Without specific requirements, “even sophisticated investors cannot understand the fees and expenses they are paying, the risks they are assuming, and the performance they are achieving in return.”
Conflicts of Interest
The SEC noted that conflicts of interest may arise when private fund advisers provide some investors with more advantageous terms than others. Smaller investors with less bargaining power may be negatively impacted when “advisers grant preferential terms to larger investors that may exacerbate conflicts of interest as well as the risks of resulting investor harm.” Conflicts of interest may arise when the fund’s assets are valued by the adviser and used as “the basis for the calculation of the adviser’s fees and fund performance.” Additionally, conflicts of interest may arise when advisers “offer existing fund investors the choice between selling and exchanging their interests in the private fund for interests in another vehicle advised by the adviser or any of its related persons as part of an adviser-led secondary transaction.” These examples provided indicated a potential for significant harm to investors, including “diminishing the fund’s returns because of excess fees and expenses paid to the fund’s adviser,” if such conflicts are not managed appropriately.
Lack of Governance Mechanisms
The SEC outlined that in a typical private fund structure, “the private fund is the adviser’s client and investors in the private fund are not clients of the adviser.” As such, “the governance structure of a typical private fund is not designed to prioritize investor oversight of the adviser and general partner or managing member (or similar control person) or investor policing of conflicts of interest.” The SEC indicated that specific rulemaking is necessary to protect all private fund investors as under the current typical private fund structure, investors “face difficulties in negotiating for reformed practices, including stronger governance structures, because of the bargaining power held by advisers and by investors who benefit from current adviser practices, such as investors who receive preferential treatment from their advisers.”
As a result of these industry factors, the SEC has adopted Final Rules for both private fund advisers registered with the SEC and all private fund advisers, regardless of registration status with the SEC. The SEC indicated that these Final Rules, as described below, are designed to protect investors who directly or indirectly invest in private funds while promoting more efficient capital markets and encouraging capital formation.
Scope of Advisers Subject to 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. Additionally, the Final Rules amend the books and records rule under the Advisers Act to facilitate the SEC’s ability to assess these advisers’ compliance with such regulations.
Regardless of registration status with the SEC, all private fund advisers must comply with the (4) Restricted Activities Rule and (5) Preferential Treatment Rule. As discussed further below, the SEC has provided legacy status provisions for certain aspects of these two rules if they relate to “governing agreements that were entered into prior to 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.”
Rules Impacting Private Fund Advisers Registered with the SEC
1. Quarterly Statement Rule
This new rule requires registered investment advisers to distribute a quarterly statement to private fund investors that includes detailed fees, expenses, and performance information.
Fee and Expense Disclosures
Registered advisers must report their fund’s fees and expenses “and any compensation paid or allocated to the adviser or its related persons by the fund, as well as any compensation paid or allocated by the fund’s underlying portfolio investments” in each quarterly statement provided to fund investors.
Private Fund-Level Disclosure
Registered advisers must provide the following disclosures to investors in a table format every quarter:
- A detailed accounting of all compensation, fees, and other amounts allocated or paid to the adviser or any of its related persons by the private fund (“adviser compensation”) during the reporting period;
- 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 paragraph (1) above (“fund expenses”); and
- The amount of any offsets or rebates carried forward during the reporting period to subsequent quarterly periods to reduce future payments or allocations to the adviser or its related persons.
Portfolio Investment-Level Disclosure
Registered advisers must disclose “a detailed accounting of all portfolio investment compensation allocated or paid to the adviser or related persons by each covered portfolio investment during the reporting period in a single table.” This rule defines “portfolio investment” as any entity or issuer in which the private fund has invested directly or indirectly. Categories expected to be separately disclosed include allocation or payments relating to origination, management, consulting, monitoring, servicing, transaction, administrative, advisory, closing, disposition, directors, trustees, or similar fees or payments by the covered portfolio investment to the adviser or any of its related persons.
Calculations and Cross-References to Organizational and Offering Documents
Registered advisers must disclose how “expenses, payments, allocations, rebates, waivers, and offsets are calculated.” The quarterly statement must also include “cross-references to the relevant sections of the private fund’s organizational and offering documents that set forth the applicable calculation methodology.”
Registered advisers are required to report standardized fund performance information in each quarterly statement provided to investors.
Performance Disclosures for Liquid Funds
For this rule, a liquid fund is defined as any private fund that is not an illiquid fund. For liquid funds, registered advisers must disclose performance based on net total return on an annual basis for the 10 fiscal years before the quarterly statement or since the fund’s inception (whichever is shorter), over one, five, and 10 fiscal year periods, and on a cumulative basis for the current fiscal year as of the end of the most recent fiscal quarter.
Performance Disclosures for Illiquid Funds
For this rule, an illiquid fund is defined as a private fund that is not required to redeem interests upon an investor’s request and has limited opportunities, if any, for investors to withdraw before termination of the fund. For illiquid funds, registered advisers must disclose the following performance measures since inception through the most recent fiscal quarter:
- Gross internal rate of return and gross multiple of invested capital for the fund;
- Net internal rate of return and net multiple of invested capital for the fund; and
- Gross internal rate of return and gross multiple of invested capital for the realized and unrealized portions of the fund’s portfolio, with the realized and unrealized performance shown separately.
These performance measures should be computed “with and without the impact of any fund-level subscription facilities.”
The rule requires quarterly statements to be distributed to investors within 45 days after the end of the first three fiscal quarter ends of each year and within 90 days after the end of each fiscal year. For fund of funds, the distribution dates are extended to 75 days and 120 days, respectively.
2. Private Fund Audit Rule
This new rule requires registered advisers to obtain an annual financial statement audit of the private funds they advise. The SEC reiterated its belief that an audit by an independent public accountant provides “an important check on the adviser’s valuation of private fund assets, which often serves as the basis for the calculation of the adviser’s fees” and protects the fund and its investors “against the misappropriation of fund assets.”
The financial statement audit is required to be performed by an independent public accountant who meets the independence requirements of 17 CFR 210.2-01 (Rule 2-01(b) and (c) of Regulation S-X) and is subject to regular inspection by the PCAOB. The audited financial statements must be prepared in accordance with generally accepted accounting principles and delivered to investors within 120 days of the fund’s fiscal year-end and “promptly” upon liquidation.
The SEC recognizes that this mandatory audit rule would eliminate the surprise examination option under the Custody Rule for private fund advisers and may increase investor costs. However, the financial statement audit provides critical information to investors to help them better understand the operations, financial position, and risks of investing in the fund. A surprise examination does not provide this information and, thus, is not an effective tool for an investor to monitor their investment. Accordingly, the SEC believes the additional costs, if any, are justified.
3. Adviser-Led Secondaries Rule
The SEC indicated that conflicts of interest exist in adviser-led secondary transactions “because the adviser and its and its related persons typically are involved on both sides of the transaction.” As a result, this new rule requires the following to be provided to investors before the due date of the election form for the transaction:
Fairness Opinion or Valuation Opinion
This rule requires registered advisers conducting an adviser-led secondary transaction to fulfill specific requirements, including obtaining and distributing either a fairness or valuation opinion to investors. Adviser-led secondary transactions generally provide the private fund investor an option to either (i) sell their interest in an existing private fund and obtain liquidity, typically at a discount to the current net asset value of the fund, or (ii) convert or exchange all or a portion of their interest in the existing private fund for interest in another vehicle advised by the adviser or a related entity. These transactions raise certain conflicts of interest because the adviser may have an opportunity to earn economic benefits such as additional management fees or carried interest upon the closing of the transaction. The SEC believes that having a third-party check through a fairness or valuation opinion when an advisor is on both sides of a transaction will protect investors against conflicted compensation schemes and reduce the possibility of “fraudulent, deceptive, or manipulative activity.”
Summary of Material Business Relationships
Additionally, registered advisers must provide a written summary of any “material business relationships between the adviser or its related persons and the independent opinion provider” within a two-year lookback period before the issuance date of the opinion.
Rules Impacting All Private Fund Advisers (Non-Registered and Registered with the SEC)
4. Restricted Activities Rule
The SEC adopted this new rule to prohibit certain activities of private fund advisers that involve conflicts of interest and compensation schemes that are “contrary to the public interest and the protection of investors unless such activities are disclosed to, and in some cases, consented to, by investors.”
This rule prohibits private fund advisers from the following two restricted activities unless investor consent is obtained:
- Charge or allocate to the private fund fees or expenses associated with an investigation of the adviser or its related persons by any governmental or regulatory authority unless the investment adviser requests and obtains written consent from at least a majority in the interest of the private fund’s unrelated investors. Regardless of consent, the investment adviser may not charge expenses related to an investigation that results in a court or governmental authority imposing a sanction for a violation of the Advisers Act; and
- Borrow money, securities, or other private fund assets, or receive a loan or an extension of credit from a private fund client unless the adviser distributes to each investor a written description of the material terms of such borrowing, loan, or extension of credit and obtains written consent from at least a majority in interest of the private fund’s unrelated investors.
Disclosure to Investors
This rule prohibits private fund advisers from the following three restricted activities unless the requirements below and written disclosures are provided to investors:
- Charge or allocate to the private fund any regulatory or compliance fees or expenses, or expenses associated with an examination of the adviser or its related persons, unless the investment adviser distributes a written notice to the investors of the nature and amount of such fees or expenses within 45 days after the end of the fiscal quarter in which the charge occurs;
- Reduce the amount of an adviser clawback by actual, potential, or hypothetical taxes applicable to the adviser, its related persons, or their respective owners or interest holders unless the investment adviser distributes a written notice to the investors disclosing the amount of such reduction within 45 days after the end of the fiscal quarter in which the adviser clawback occurs; and
- Charge or allocate fees or expenses related to a portfolio investment (or potential portfolio investment) on a non-pro rata basis when multiple private funds and other clients advised by the adviser or its related persons have invested (or propose to invest) in the same portfolio investment, unless (i) the non-pro rata charge or allocation is fair and equitable under the circumstances and (ii) a written notice of the non-pro rata charge or allocation and a description of how it is fair and equitable is distributed to investors prior to being incurred.
The SEC has provided legacy status “for the aspects of the restricted activities rule that requires investor consent, which restrict an adviser from borrowing from a private fund and from charging for certain investigation fees and expenses.” The legacy status provisions are relevant for governing agreements that were “entered into prior to the compliance date if the rule would require the parties to amend such an agreement” and for funds that commenced operations as of the compliance date. This legacy treatment is intended to reduce the need for advisers and investors to “renegotiate contractual agreements at a significant cost to the industry.”
5. Preferential Treatment Rule
The SEC adopted this new rule to address their concerns that private fund advisers may have sales practices that “do not provide all investors with sufficient detail regarding preferential terms granted to other investors.” The SEC reiterated that “disclosure (and in some cases prohibition) of preferential treatment is necessary to guard against fraudulent and deceptive practices.”
As a result, this rule requires that all private fund advisers be prohibited from providing “preferential treatment with respect to redemption rights and portfolio holdings or exposure information, in each instance, that the adviser reasonably expects would have a material, negative effect on other investors.”
This rule prohibits private fund advisers from the following:
- Granting an investor in a private fund the ability to redeem its interest on terms that the adviser reasonably expects to have a material, negative effect on other investors in that private fund, with an exception for redemptions that are required by applicable law, rule, regulation, or order of certain governmental authorities, and if the adviser offers the same redemption ability to all existing and future investors in the private fund; or
- Providing information regarding the portfolio holdings or exposures of the private fund to any investor in the private fund if the adviser reasonably expects that providing the information would have a material, negative effect on other investors in that private fund, with an exception where the adviser offers such information to all other existing investors at substantially the same time.
Additionally, this rule requires disclosure for all other types of preferential treatment to any investor in a private fund. Private fund advisers must provide (i) to each prospective investor in the private fund, before investment, a written notice that provides specific information regarding any preferential treatment related to any material economic terms that the adviser or its related persons provide to other investors in the same private fund, (ii) written disclosure of all preferential treatment the adviser or its related persons has provided to other investors in the same private fund, and (iii) on at least an annual basis, a written notice that provides specific information regarding any preferential treatment provided by the adviser or its related persons to other investors in the same private fund since the last written notice.
The SEC has provided legacy status to private fund advisers “under the prohibitions aspect of the preferential treatment rule, which prohibits advisers from providing certain preferential redemption rights and information about portfolio holdings.”
The legacy status provisions are relevant for governing agreements that were “entered into prior to the compliance date if the rule would require the parties to amend such an agreement” and for funds that commenced operations as of the compliance date.
Importantly, the SEC has not provided legacy status to private fund advisers for the disclosure aspect of the preferential treatment rule, so this rule would only apply to new agreements (e.g., side letters entered into after the compliance date). As such, “information in side letters that existed before the compliance date will be disclosed to other investors that invest in the fund post compliance date.” The SEC has indicated that advisers may report this information anonymously rather than disclose the specific identity of investors that received such preferential terms.
Amended Advisers Act Compliance Rule
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 allow the SEC’s staff to “better determine whether an adviser has complied with the review requirement of the compliance rule and will facilitate remediation of non-compliance.”
The SEC is adopting an 18-month transition period for all private fund advisers for the Quarterly Statement and Private Fund Audit Rule.
The SEC is adopting staggered compliance dates for the Adviser-Led Secondaries Rule, Restricted Activities Rule, and Preferential Treatment Rule. Advisers with $1.5 billion or more in private funds assets under management (“Larger Private Fund Advisers”) have a 12-month transition period for these rules. Advisers with less than $1.5 billion in private funds assets under management (“Smaller Private Fund Advisers”) have an 18-month transition period for these rules.
As the SEC forges ahead with implementing these groundbreaking Final Rules under the Advisers Act, the landscape for private fund advisers and investors is poised for a significant transformation. Private fund advisers will find themselves navigating a more rigorous regulatory environment, requiring them to revisit and revise their agreements, policies, and operational processes. These changes will necessitate a heightened focus on transparency, due diligence, and compliance. While adapting to these new regulatory requirements may present challenges, they also offer an opportunity for private fund advisers to strengthen their relationships with investors and enhance their creditability and accountability.
For investors, these Final Rules represent a vital step towards greater protection and transparency within the investment landscape. Investors can look forward to enhanced disclosures, improved risk assessments, and a clearer understanding of the services provided and fees charged by private fund advisers. As a result, investors will be better equipped to make informed decisions about their investments, ultimately fostering greater confidence in the financial markets.
The road ahead may present challenges in implementation, but the ultimate goal is to create a more secure and equitable investment landscape for all stakeholders involved.