SEC Proposes New Rules and Amendments Applicable to Private Fund Advisers

On February 9, 2022, the U.S. Securities and Exchange Commission (the “SEC”) proposed new rules and amendments under the Investment Advisers Act of 1940 (the “Advisers Act”) to augment the regulation of private fund advisers. The new rules and amendments are intended to bring greater transparency, comparability, and accountability to the private funds sector. Some of the proposed new rules reflect market practice or existing requirements (including existing requirements of the CFTC that may apply to certain advisers), but some of the proposed rules are a departure from market practice and will require that advisers reevaluate their current practices and business model.

The SEC estimates that private fund advisers manage over $18 trillion in gross assets of accredited investors. In his statement supporting the proposals, SEC Chairman Gary Gensler noted although investors in private funds are all accredited investors, many private funds are held by intermediaries, including state, municipal and private pension plans, that represent retirement and other savings of American retail investors.

The proposed new rules and amendments would:

1) Require Registered Private Fund Advisers to Deliver Quarterly Statements.

In an effort to improve the quality of information provided to private fund investors and allow them to better assess, monitor, and compare their private fund investments, the SEC is proposing to require registered investment advisers to private funds to distribute a quarterly statement to private fund investors within 45 days of each calendar quarter end. The report would include: (i) a detailed accounting of all fees and expenses paid by the private fund to the adviser or any of its related persons during the reporting period; (ii) information regarding compensation or other amounts paid by the private fund’s portfolio investments to the adviser or any of its related persons during the reporting period; and (iii) information regarding the private fund’s performance during the reporting period. The adviser would also be required to prominently disclose the manner in which expenses, payments, allocations, rebates, waivers, and offsets are calculated.

Specifically, the quarterly statements would require disclosure of the following information in a table format:

• 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 during the reporting period, both before and after the application of any offsets, rebates or waivers;
• A detailed accounting of all fees and expenses paid by the private fund during the reporting period other than those listed immediately above (for example, organizational, accounting, legal, administration, audit, tax, due diligence, and travel expenses), both before and after the application of any offsets, rebates or waivers; 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.

Registered advisers to private funds would also be required to include a table summarizing portfolio investment compensation in the required quarterly reports. Such table would cover direct and indirect portfolio investments and would include:

• A detailed accounting of all portfolio investment compensation allocated or paid by each covered portfolio investment during the reporting period, both before and after the application of any offsets, rebates, or waivers; and
• The private fund’s ownership percentage of each covered portfolio investment as of the end of the reporting period (both before and after the application of any offsets, rebates, or waivers) or, if the fund does not have an ownership interest in the covered portfolio investment, the adviser would be required to list zero percent as the fund’s ownership percentage along with a brief description of the fund’s investment in such covered portfolio investment.

The proposed rule would also require an adviser to include standardized fund performance information in each quarterly statement, including prominent disclosure of the criteria used and assumptions made in calculating the performance. For liquid funds, the quarterly statement would provide annual net total returns since inception, average annual net total returns over prescribed time periods, and quarterly net total returns for the current calendar year. For illiquid funds (e.g., closed-end funds that do not offer periodic redemption options), the statement would provide the gross and net internal rate of return and gross and net multiple of invested capital for the illiquid fund to capture performance from the fund’s inception through the end of the current calendar quarter.

2) Require Audits of Private Funds’ Financial Statements.

The proposal would require a registered investment adviser providing advice to private funds to cause the private fund to undergo a financial statement audit, at least annually and upon liquidation, by an independent public accountant registered with and subject to inspection by the Public Accounting Oversight Board (“PCAOB”). The investment adviser would also be required to ensure that, promptly after completion of such audit, the financial statements are distributed to investors in the private funds. In general, the financial statements would be required to be prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”). For private funds organized under non-U.S. law, financial statements would be required to contain information substantially similar to financial statements prepared in accordance with U.S. GAAP and a reconciliation of material differences with U.S. GAAP. The SEC noted that such audits are intended to provide a check on the adviser’s valuation of fund assets, which frequently serves as the basis of the adviser’s fees, and offer a measure of prevention against misappropriation of fund assets. The proposed audit rule is based on existing Rule 206-4(2) under the Advisers Act (the “custody rule”) and contains many similar or identical requirements, although compliance with either rule would not automatically satisfy the requirements of the other.

The proposed rule would also require a registered investment adviser that provides advice to private funds to enter into, or cause the private fund to enter into, a written agreement with the independent public accountant performing the fund’s audit to notify the SEC’s Division of Examinations electronically: (i) promptly upon issuing an audit report to the private fund that contains a modified opinion; and (ii) within four business days of resignation or dismissal from, or other termination of, the engagement, or upon removing itself or being removed from consideration for being reappointed.

3) Require a Fairness Opinion in Connection with Adviser-Led Secondary Transactions.

The proposal would require a registered private fund adviser, in connection with an adviser-led secondary transaction, to distribute to investors in a private fund, prior to the closing of the transaction, a fairness opinion (prepared by an independent opinion provider) and a written summary of material business relationships between the adviser and the opinion provider in the preceding two years. In an adviser-led secondary transaction, advisers offer existing fund investors the option to sell or exchange their interests in a private fund for interests in another vehicle advised by the adviser or its affiliates, resulting in the adviser (or its affiliates, as applicable) being on both sides of the transaction. The fairness opinion is intended to provide a check against an adviser’s conflicts of interest in structuring a transaction from which it may stand to profit at the expense of investors.

4) Prohibit Certain Practices.

The proposal would prohibit all private fund advisers, including unregistered and exempt reporting advisers, from engaging in certain activities and practices, including:

• Charging certain fees and expenses to a private fund or its portfolio investments, such as fees for unperformed services (e.g., accelerated monitoring fees) and fees associated with an examination or investigation of the adviser by the SEC or another governmental or regulatory authority;
• Seeking reimbursement, indemnification, exculpation, or limitation of its liability in certain circumstances (e.g., indemnification for breach of a fiduciary duty or negligence);
• Netting a clawback obligation by the amount of certain taxes;
• Allocating fees or expenses related to a portfolio investment among a private fund and other entities advised or related to the adviser on a non-pro rata basis; and
• Borrowing money, securities or other fund assets, or receiving an extension of credit from a private fund client.

This proposal is intended to address certain conflicts of interest that the SEC is concerned cannot be “cleansed” by disclosure alone.

5) Prohibit, or Require Disclosure of, Preferential Treatment.

The proposal would prohibit all private fund advisers, including unregistered and exempt reporting advisers, from providing preferential terms to certain (but not all) investors regarding redemptions from the fund or information about portfolio holdings or exposures. All other preferential treatment would need to be disclosed to current and prospective investors in writing. This proposal is intended to protect investors by prohibiting specific types of preferential treatment that could have a material dilutive or negative effect on other investors and enhance transparency during the negotiation process.

6) Require Retention of Related Records and Written Annual Review.

In connection with the proposed new rules outlined above, investment advisers will be required to retain copies and records related to the new rules to bolster the SEC’s ability to enforce compliance. In addition, all registered investment advisers, including those that do not advise private funds, will need to document their annual compliance reviews in writing to help the SEC identify potential weaknesses and assess compliance.

The public comment period will remain open for 60 days following publication of the proposing release on the SEC’s website or 30 days following publication of the proposing release in the Federal Register, whichever period is longer.