SEC Adopts Expansive Private Fund Adviser Rules

On August 23, 2023, the SEC adopted new rules and amendments to existing rules (collectively, the “New Rules”) under the Investment Advisers Act of 1940 (the “Advisers Act”). The New Rules are designed to increase transparency for private fund investors, address conflicts of interest that the SEC staff believes are “commonly present” in private fund adviser practices, and address perceived risk of harm to private fund investors arising from private fund governance structures.

Investment advisers affected by the New Rules should not underestimate the time or cost necessary to implement the requirements of the New Rules. The New Rules represent a significant shift in the amount and types of disclosure that will be required to be provided to investors in private funds. In some cases (e.g., the audit rule discussed below), private fund advisers may need to identify and enter into contracts with new service providers. In short, advisers will need to significantly overhaul their compliance and operational procedures in a relatively short timeframe to ensure compliance with these new requirements.

While the New Rules remain subject to challenge and certain aspects of the New Rules require further clarification, the outline below sets forth a high-level overview of the New Rules (as currently drafted) and their potential impact on the key players in the industry – namely investment advisers and private fund investors. Our FAQ page sets out responses to our clients’ most frequently asked questions on the New Rules.

This overview and our FAQ responses are intended to provide investment advisers and other professionals with a general overview of the information contained in SEC Release No. IA-6383. Industry practice will undoubtedly evolve as the New Rules are clarified, further interpreted, and implemented.

Summary of the New Rules:

Among other things, the New Rules:

• require registered investment advisers that manage private funds to:
• obtain an audit of private funds that is consistent with existing obligations under the Advisers Act custody rule;
• provide quarterly statements to investors in each fund, including standardized performance reporting;
• obtain either a fairness opinion or a valuation opinion in connection with GP-led secondaries; and
• memorialize the adviser’s annual review of its compliance program in a written report;
• restrict all advisers (including exempt reporting advisers) that manage private funds (other than securitized asset funds) from certain activities (largely related to the allocation of fees and expenses to investors and certain sales practices) without disclosure to investors and, in some cases, consent of investors (referred to as the “restricted activities rule”); and
• prohibit all advisers (including exempt reporting advisers) that manage private funds from entering into side letters that result in preferential treatment with respect to redemption rights and portfolio holdings or exposure information (referred to as the “preferential treatment rule”). The preferential treatment rule also imposes new disclosure obligations related to side letters.

Compliance Timeline

The New Rules will be effective 60 days after the date of publication in the Federal Register. Investment advisers will have between 60 days and 18 months to come into compliance with the New Rules, as set forth below:

• Implementation of the New Rules related to private fund audits and distribution of quarterly statements is required within 18-months for all registered private fund advisers.
• Advisers with $1.5 billion or more in private funds assets under management must adhere to a 12-month transition period for the adviser-led secondaries rule, the preferential treatment rule, and the restricted activities rule.
• Advisers with less than $1.5 billion in private fund assets under management will have 18-months to comply with the adviser-led secondaries rule, the preferential treatment rule, and the restricted activities rule.
• Compliance with the amended Advisers Act compliance rule will be required 60 days after publication in the Federal Register.

Legacy Provision. If the application of either the restricted activities rule or the preferential treatment rule would require an investment adviser and a private fund that has commenced operations as of the compliance date of the New Rules to amend written contractual agreements governing the fund that were entered into prior to the compliance date of the New Rules, then the investment adviser and the private fund will not be required to amend such contractual arrangements. Private fund advisers should be aware that, for purposes of the disclosure requirements in the preferential treatment rule, certain information in existing side letters, other than the specific investor that received a preferential term, will be disclosed to other investors that invest in a fund post compliance date.

For purposes of claiming legacy status, “commencement of operations” includes, for example, issuing capital calls, setting up a subscription facility for the fund, holding an initial fund closing, conducting due diligence on potential fund investments, or making an investment on behalf of the fund. Contractual agreements covered by the legacy provision must be in writing and include, but are not limited to, a private fund’s operating or organizational agreements (e.g., the limited partnership agreement, the limited liability company agreement, articles of association, or by‑laws), the subscription agreements, side letters, promissory notes, and credit agreements.

Key Provisions – Registered Investment Advisers

Quarterly Statements. Registered investment advisers will be required to provide investors in private funds managed by the advisers with quarterly statements including information related to fees and expenses paid by investors in the fund and performance received on such investments over the preceding quarter. The SEC noted that this information will “improve investors’ ability to evaluate the adviser’s conflicts of interest with respect to the fees and expenses charged to the fund by the adviser and the performance metrics that the adviser presents to investors.”

Quarterly statements are due within 45 days of the end of the first three quarters of the year (75 days for funds of funds) and within 90 days after the end of the fiscal year (120 days for funds of funds).

Quarterly statements will be required to include:

• A table that includes the following data (both before and after the offset of offsets, rebates, or waivers):
• all compensation, fees, and other amounts (e.g., management, advisory, sub-advisory, or similar fees or payments, and performance-based compensation) allocated or paid to the investment adviser or any of its related persons by the private fund during the reporting period;
• all other fees and expenses allocated to or paid by the private fund during the reporting period including, but not limited to, organizational, accounting, legal, administration, audit, tax, due diligence, and travel fees and expenses; and
• the amount of any offsets or rebates carried forward during the reporting period.
• A table summarizing all compensation, fees, and other amounts allocated or paid to the investment adviser or any of its related persons by portfolio companies that is attributable to the private fund’s interest in such portfolio companies, including, but not limited to, origination, management, consulting, monitoring, servicing, transaction, administrative, advisory, closing, disposition, directors, trustees, or similar fees or payments.
• Prominent disclosure regarding the manner in which all expenses, payments, allocations, rebates, waivers, and offsets are calculated, including cross references to the sections of the private fund’s organizational and offering documents that set forth the applicable calculation methodology.
• In the case of a private fund with limited redemption and withdrawal rights (an “illiquid fund”), the following performance measures, calculated since inception of the illiquid fund through the end of the quarter covered by the quarterly statement and computed both with and without the impact of any fund-level subscription facilities:
• gross and net internal rates of return (IRR) for the fund as a whole;
• gross and net multiples of invested capital (MOIC) for the fund as a whole;
• gross IRR and gross MOIC for the realized and unrealized portions of the illiquid fund’s portfolio, with the realized and unrealized performance shown separately; and
• a statement of contributions and distributions.
• In the case of all other private funds (“liquid funds”):
• annual net total returns for each fiscal year over the past 10 fiscal years or since inception, whichever time period is shorter;
• average annual net total returns over the one-, five-, and 10-fiscal-year periods; and
• cumulative net total return for the current fiscal year as of the end of the most recent fiscal quarter covered by the quarterly statement.

Mandatory Private Fund Audits. Registered investment advisers to private funds will be required to obtain an annual financial statement audit of the private funds they advise, directly or indirectly. The SEC noted that the audit requirement is, among other things, designed to provide a check on the adviser’s valuation of private fund assets, as well as testing of the calculation and presentation of management fees and performance fees due to the adviser or tis related persons.

The audit requirement is based on, and largely consistent with, the requirements of Rule 206(4)-2 under the Advisers Act (the “Custody Rule”). Accordingly, among other things:

• Audits must be performed by an independent public accountant that meets the standards of independence in Regulation S-X and that is registered with, and subject to regular inspection by the Public Company Accounting Oversight Board (“PCAOB”);
• Audited financial statements must be prepared in accordance with generally accepted accounting principles; and
• Annually, within 120 days of the private fund’s fiscal year-end, and promptly upon liquidation, the private fund’s audited financial statements must be delivered to investors in the private fund.

In the case of a private fund that is neither controlled by nor under common control with the adviser (e.g., a fund of funds that invests in underlying funds managed by unaffiliated sub‑advisers) the adviser need only take “all reasonable steps” to cause the underlying private fund to undergo such an audit.

Adviser-Led Secondaries. Registered investment advisers that initiate a transaction that offers investors in a private fund the option between selling all or a portion of their interest in the private fund or converting or exchanging such interests for new interests in another vehicle advised by the adviser or its related persons will be required to:

• obtain a fairness opinion or a valuation opinion from an independent opinion provider and distribute the opinion to private fund investors prior to the due date of the election form; and
• prepare and distribute a written summary of any material business relationships between the adviser or its related persons and the independent opinion provider.

The SEC noted that adviser-led secondaries create a conflict of interest between a private fund and its registered investment adviser, because the adviser is incentivized to recommend that a private fund sell its assets to a continuation vehicle because the adviser and its related persons will typically receive additional management fees and carried interest from managing the continuation vehicle. By ensuring that private fund investors that participate in a secondary transaction are offered an appropriate price and provided disclosures about the opinion provider’s relationship with the adviser, the SEC believes that this rule will reduce the possibility of fraudulent, deceptive, or manipulative activity on the part of investment advisers.

Although intended to protect investors, fairness and valuation opinions are subject to numerous assumptions and speak only to the fairness or valuation of the transaction consideration as of a particular date, which usually precedes the closing date. Fairness opinions are not necessarily responsive when consideration is not solely cash. Furthermore, the cost burden of obtaining such opinions is likely to be passed on to investors.

Under the New Rules registered investment advisers and investors in the private funds that they manage will have the ability to negotiate whether a fairness opinion or valuation opinion is more appropriate.

Annual Compliance Written Report. The New Rules include amendments to Rule 206(4)-7, the compliance rule under the Advisers Act, that will require all registered advisers, including those that do not advise private funds, to document in writing the required annual review of their compliance policies and procedures. The rule does not prescribe a specific format of the written document, and investment advisers will be free to determine the report that works best for them.

Written documentation of the annual review will help the SEC’s examination staff to determine if advisers are complying with the compliance rule. The new requirement will also, of course, potentially provide a roadmap for potential referrals to the SEC’s enforcement staff.[1] The SEC noted that any request for the written report should be promptly[2] produced to SEC staff upon request. Moreover, the SEC cautioned advisers against seeking to rely on “improper claims of attorney-client privilege, the work-product doctrine or other similar protections.”

Key Provisions – All Advisers (including Exempt Reporting Advisers) 

Restricted Activities Rule. An investment adviser to a private fund (other than a securitized asset fund) may not, directly or indirectly, do the following with respect to the private fund, or any investor in that private fund:

• charge or allocate to the private fund fees or expenses associated with an investigation of the adviser without disclosure to and seeking consent from all fund investors and receiving written consent from at least a majority of fund investors that are not related persons of the investment adviser;
• under any circumstances, charge fees, or expenses related to an investigation that results or has resulted in a court or governmental authority imposing a sanction for a violation of the Advisers Act or the rules promulgated thereunder;
• charge or allocate to the private fund regulatory, examination, or compliance fees or expenses of the adviser, unless such fees and expenses are disclosed to investors in a written notice, including the total dollar amount of such fees or expenses, within 45 days after the end of a fiscal quarter in which such charge occurs;
• reduce the amount of an adviser’s clawback by the amount of actual, potential, or hypothetical taxes applicable to the investment adviser or its related persons, unless the adviser discloses in writing the pre-tax and post-tax amount of the clawback to investors within 45 days after the end of the fiscal quarter in which the clawback occurs;
• charge or allocate fees or expenses related to a portfolio company on a non-pro rata basis, unless the allocation approach is fair and equitable and the adviser distributes advance written notice of the non-pro rata charge and a description of the proposed charge or allocation and why its approach is fair and equitable under the circumstances; and
• borrow or receive an extension of credit from a private fund client without disclosure to all investors and receipt of written consent from at least a majority of fund investors that are not related persons of the investment adviser.

The enhanced disclosure requirements related to the restricted activities rule will increase compliance burdens and associated regulatory costs for all investment advisers, even if such investment advisers are successful in maintaining their current practices of charging the fees, expenses and indemnification reimbursements described above to the private funds they advise. The restricted activities rule and the New Rules in general are likely to enhance the risk of regulatory action, including public regulatory sanctions. If an investment adviser is prohibited from passing on related costs to the private funds it advises, either by way of categorizing such fees and expenses as partnership expenses or seeking indemnification reimbursement, the investment adviser will need to bear such amounts and the cost of insurance, specifically D&O and E&O insurance, could significantly increase or such insurance coverage may become unavailable, as a consequence.

Preferential Treatment Rule. The New Rules prohibit all investors advisers to private funds (excluding securitized asset funds) from directly or indirectly:

• giving an investor in a private fund the right to redeem its interest on terms that the adviser reasonably expects to have a material, negative effect on other investors in that private fund or in a similar pool of assets, unless the ability to redeem is required by applicable law or the adviser offers the preferential redemption rights to all other existing and future investors in that private fund without qualification; and
• providing preferential information about portfolio holdings or exposures of 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, unless such preferential information is offered to all existing investors in the private fund at the same time.

The preferential treatment rule prohibits all private fund advisers from providing such preferential treatment to any investor in a private fund, unless:

• the investment adviser provides to each prospective investor in the private fund a written notice that provides information regarding any preferential treatment related to any material economic terms that the adviser or its related persons provide to other investors in the private fund;
• the investment adviser distributes to current investors in illiquid funds, as soon as reasonably practicable following the end of the private fund’s fundraising period, written disclosure of all preferential treatment the adviser or its related persons has provided to other investors in the private fund;
• the investment adviser distributes to each investor in a liquid fund, as soon as reasonably practicable following an investor’s investment in a private fund, written disclosure of all preferential treatment the adviser or its related persons has provided to other investors in the private fund; and
• on at least an annual basis, the investment adviser distributes a written notice to all investors in a private fund managed by that adviser that provides specific information regarding any preferential treatment provided by the adviser or its related persons to other investors in the private fund since the last such written notice, if any.

The preferential treatment rule is intended to enhance transparency during the negotiation process and protect investors by prohibiting specific types of preferential treatment, unless required by applicable law, that could have a material dilutive or negative effect on other investors. The preferential treatment rule will undoubtedly alter advisers’ practices with respect to side letters and most favored nations (“MFN”) processes. Terms that advisers may have been willing to grant select investors in the past on the basis that they would not need to be disclosed and/or offered to other investors (such as under an MFN provision) may become more controversial, with advisers becoming more hesitant to grant these terms if they need to be disclosed and/or offered to all investors. Investors will need to reevaluate whether obtaining these terms are absolute requirements for them and whether any redemption rights they previously requested can be described as being required by applicable law, rather than internal policy. Advisers’ hesitancy to grant terms they previously agreed to will likely result in extended side letter negotiations, increasing a fund’s organizational costs and the investor’s own legal costs related to the investment.

Changes from the Proposal

Proposed Waiver of Indemnification. The New Rules do not include the proposed rule that would have prohibited an adviser to a private fund, directly or indirectly, from seeking reimbursement, indemnification, exculpation, or limitation of liability for (among other things) ordinary negligence. This change is consistent with comments made by many in the industry raising concerns that, among other things, the proposed prohibition would have resulted in “more onerous liability standards for sophisticated investors than for retail investors and that such a difference would result in better protection for institutional investors than for investors in retail products.”

Instead, the SEC took the opportunity to reaffirm and clarify “its views on how an adviser’s fiduciary duty applies to its private fund clients and how the antifraud provisions apply to the adviser’s dealings with clients and fund investors.” The SEC staff reiterated its position that any waiver of an adviser’s obligations under the Advisers Act, including its fiduciary duty and compliance with the anti-fraud provisions in Section 206 of the Advisers Act, is invalid.

The SEC noted that, if a contractual clause that purports to limit an adviser’s liability creates a conflict of interest between an adviser and its client (i.e., a private fund) then the adviser “must address the conflicts as required by its duty of loyalty.” Moreover, the SEC stated that it believes that “an adviser may not seek reimbursement, indemnification, or exculpation for breaching its Federal fiduciary duty because such reimbursement, indemnification, or exculpation would operate effectively as a waiver, which would be invalid under the Act.” Similarly, the SEC would consider an adviser that charges to its private fund clients fees and expenses related to an investigation that results in the imposition of sanctions against the adviser for a violation of the Advisers Act and its related rules to be invalid under the Advisers Act.

The SEC’s comments underscore their enhanced scrutiny of investment advisers’ practices with respect to addressing conflicts and narrowing fiduciary duties by contract. Investment advisers should carefully review how conflicts are being addressed in the governing documents for the private funds they advise and ensure they are in-line with the views expressed above.

No SEC Notification by Auditors. The proposed rules would have required a registered adviser to a private fund to enter into, or cause the private fund to enter into, a written agreement with the independent public accountant performing the private fund audit to notify the SEC (i) “promptly” upon issuing an audit report to the private fund that contained 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. The SEC stated that it decided not to adopt this reporting requirement in order to align the audit requirement with those in the Custody Rule. However, the SEC’s currently proposed safeguarding rule[3] would require advisers to enter into a similar written agreement with the independent public accountant performing the audit.

Fees for Unperformed Services. The SEC also determined not to adopt a proposed prohibition on charging portfolio companies for monitoring, servicing, consulting, or other fees related to services that an investment adviser does not, or does not reasonably expect to, provide to the portfolio company. The SEC stated that such prohibition was not necessary since such activity “would cause the adviser to place its own interests ahead of its client’s interests, as more fully described in the paragraph below, we have determined that it is unnecessary to prohibit activity that is already indirectly inconsistent with the adviser’s fiduciary duty.”

[1] Advisers in an organization that includes multiple investment advisers should note that the change to the compliance rule under the Advisers Act will require each individual adviser to produce the required written report of the annual compliance review.

[2] In a note to the adopting release, the SEC noted that it expects that a fund or adviser would be permitted to delay furnishing electronically stored records for more than 24 hours only in unusual circumstances.

[3] On the same day it adopted the New Rules, the SEC reopened comments on its proposed Enhanced Safeguarding Rule for Registered Investment Advisers which, as proposed would redesignate and amend the Custody Rule.