The Securities and Exchange Commission (SEC) recently green-lit new regulations on private fund advisers meant to better inform and protect investors in private funds.
The final rule – which includes some rules applicable only to SEC-registered investment advisers (RIAs) to private funds, as well as some applicable to all private fund advisers – is a much more toned-down version of what was originally proposed in February 2022.
Nonetheless, the rules will require more transparency on the part of private fund advisers and will clamp down on certain practices thought to be detrimental to investors.
The following are the key aspects of the final rule, which will need to be implemented across various timelines over the next two years.
Rules Applicable Only to Registered Private Fund Advisers
Quarterly Statement Rule
Registered private fund advisers must distribute a quarterly statement to private fund investors that outlines private fees and expenses (including any compensation the fund paid or allocated to the advisor or related persons, and any compensation paid or allocated by the fund’s underlying portfolio investments); compensation received by the RIA and its affiliates and personnel and any other related fee offsets; and fund performance.
“Private funds are often more expensive than other asset classes because the scope and magnitude of fees and expenses paid directly and indirectly by private fund investors can be extensive and complex,” the final rule says, and the quarterly statement will help current investors better understand the cost of their investments.
The expenses to be reported now include expenses allocated to the fund, as well as expenses paid by the fund. These fees and expenses are effectively broken down into three parts:
- Private fund-level disclosure: In table format, an accounting of all fees, expenses, compensation, offsets, waivers, and more.
- Portfolio investment-level disclosure: Also in table format, an accounting of all portfolio investment compensation allocated or paid by each covered portfolio investment.
- Calculations and cross-references to organizational and offering documents: Each statement must include prominent disclosure about how expenses, payments, compensation, etc., are calculated. The statement also must include cross-references to relevant parts of the private fund’s organizational and offering documents that describe any applicable calculation methodologies.
Meanwhile, private fund advisers will also be required to provide quarterly standardized fund performance information. For liquid funds, this will include annualized data for one-, five-, and 10-year periods (or since inception, if shorter than any of these periods), and cumulative data for the fiscal year-to-date as of the end of the most recent fiscal quarter. For illiquid funds, it will include internal rates of return and multiples of invested capital since inception.
Private Fund Audit Rule
Private fund advisers will now be required to obtain an annual financial statement audit of each private fund they advise, whether directly or indirectly. Under the new rule, this audit must adhere to the same standards as the Custody Rule’s audit requirements. Additionally, if an RIA is not in a control relationship with the fund, it must maintain records documenting its efforts to undergo an annual audit.
Adviser-Led Secondaries Rule
Registered private fund advisers engaging in an adviser-led secondary transaction must now meet two new requirements:
- Obtain a fairness opinion or a valuation opinion from an independent opinion provider and distribute the opinion to investors before the election form’s due date.
- Disclose to investors a written summary of any material business relationships between the adviser or any related persons and the independent opinion provider within the two years prior to when the fairness or valuation opinion was issued.
Rules Applicable to All Private Fund Advisers
Restricted Activities Rule
The final rule also places some restrictions on certain activities by all private fund advisers. Private fund advisers are strictly prohibited from:
- Charging or allocating to the private fund fees or expenses related to an investigation that results or has resulted in a court or governmental authority imposing a sanction for violating the Investment Advisers Act of 1940.
Private fund advisers are restricted from engaging in the following activities unless they satisfy certain disclosure (and, in some cases, consent) requirements:
- Charging or allocating to the private fund fees or expenses associated with an investigation of the adviser without disclosure to (and consent from) fund investors.
- Charging or allocating to the private fund regulatory, examination, or compliance fees or expenses of the adviser without disclosing the fees and expenses to investors.
- Reducing the amount of an adviser clawback by the amount of certain taxes without disclosing pre-tax and post-tax amounts of the clawback to investors.
- Charging or allocating fees or expenses related to a portfolio investment on a non-pro rata basis without distributing advance written notice of the no-pro rata charge and a description of how the allocation approach is fair and equitable under the circumstances.
- Borrowing or receiving an extension of credit from a private fund client without disclosure to (and consent from) fund investors.
Under the new rule, the following activities are permitted with disclosure:
- Causing the fund to bear regulatory or compliance fees/expenses. (These must be disclosed after the fact, on a quarterly basis, via quarterly reports.)
- Reducing GP clawback for taxes. (Pre-tax and post-tax clawback amounts must be disclosed after the fact.)
- Non-pro rata allocations of investment-related expenses across different funds investing in the same investment. (The fees/expense must be disclosed before the fact, along with an explanation as to why the fund’s allocation is fair and equitable.)
Under the new rule, the following activities are permitted with disclosure and consent:
- Causing the fund to bear fees/expenses relating to investigations (other than in cases where the adviser is sanctioned for violating the Advisers Actor or the rules thereunder).
- Borrowing from a fund.
This list was winnowed down significantly from the original proposal, which would have outright prohibited all of these behaviors rather than merely required disclosure and/or consent.
Preferential Treatment Rule
All private fund advisers, with exceptions, will be prohibited from:
- Granting an investor in a private fund or in a substantially similar pool of assets the ability to redeem interest on terms that the adviser expects would have a material, negative effect on other investors in that private fund or in a substantially similar pool.
- Providing information regarding portfolio holdings or exposures of a private fund or of a substantially similar pool of assets to any investor if the adviser would reasonably expect that providing the information would have a material, negative effect on other investors in that private fund or in a substantially similar pool.
- Providing any other preferential treatment to any investor in the private fund unless the adviser delivers certain written disclosures to prospective and current investors regarding all preferential treatment the adviser or its related persons provide to other investors in the same fund.
Exceptions to the redemption rights prohibition include a.) redemptions required by applicable law, rule, regulation, or order of certain governmental authorities, and b.) instances in which the adviser has offered the same redemption ability to all existing investors and will continue to offer that same redemption ability to all future investors.
Exceptions to the preferential information rights includes instances in which the adviser offers such information to all other existing investors in the private fund at the same time or substantially the same time.
Advisers must also provide private fund investors written notice of all preferential treatment that the adviser has provided to other investors in the same private fund.
Rules Applicable to All Registered Advisers
Compliance Rule Amendments
The final rule also creates new amendments to the compliance rule under the Advisers Act requiring all registered advisers (including those who do not advise private funds) to document in writing the required annual review of their compliance policies and procedures.
Compliance Date Schedule
- Quarterly Statement Rule and Private Fund Audit Rule: 18 months after the date of publication in the Federal Register.
- Adviser-Led Secondaries Rule, Preferential Treatment Rule and Restricted Activities Rule:12 months after the date of publication in the Federal Register for advisers with $1.5 billion or more in private funds assets under management, and 18 months after the date of publication in the Federal Register for advisers with less than $1.5 billion in private funds AUM.
- Advisers Act Compliance Amendments: 60 days after publication in the Federal Register.
For more information on the new rule, please see the SEC’s fact sheet here.
If your firm needs assistance complying with these new regulations, please contact us.
