On Aug. 23, 2023, the U.S. Securities and Exchange Commission (SEC) adopted a sweeping package of reforms that will have a significant and lasting impact on most private fund advisers, regardless of whether they are registered with the SEC.
The rules prohibit or restrict various types of activities, some of which have been customary in the private fund industry. The rules will also require advisers that are registered, or required to register, with the SEC to, among other things, provide fund investors a detailed quarterly statement disclosing adviser compensation, fund expenses and fund performance; to obtain an annual financial statement audit of the private funds they advise; and to document the annual compliance reviews.
Although the final rules are not as onerous as originally conceived, the rules will nonetheless have a large impact on the business and operations of many private fund advisers.
The following is a summary of the adopted rules and the impact they will have on private fund advisers.
Rules Impacting Registered Advisers
Certain of the rules will impact only those private fund advisers registered with or required to be registered with the SEC pursuant to the Investment Advisers Act of 1940 (Advisers Act), which are described below in more detail.
New Disclosure Requirements
To promote more transparency and to facilitate investor comparison of different funds in the marketplace, Rule 211(h)(1)-2 under the Advisers Act (the “Quarterly Statement Rule”) requires registered advisers to provide quarterly statements to fund investors detailing adviser compensation, fund expenses and portfolio holdings and performance, unless a third party is already preparing and distributing such reports to fund investors.
If the private fund is not a fund of funds, then a quarterly statement must be distributed within 45 days after the end of each of the first three fiscal quarters of each fiscal year, and 90 days after the end of each fiscal year. If the private fund is a fund of funds, then a quarterly statement must be distributed within 75 days after the first, second and third fiscal quarter ends, and 120 days after the end of the fiscal year of the private fund.
The quarterly statement rule will only require quarterly statements by new funds after the fund’s second full quarter of generating operating results. If an adviser is unable to deliver the quarterly statement in the timeframe required under the quarterly statement rule due to reasonably unforeseeable circumstances, this will not provide a basis for enforcement action so long as the adviser reasonably believes that the quarterly statement will be distributed by the applicable deadline and the adviser delivers the quarterly statement as promptly as practicable.
For starters, the report must include, in a table format, disclosures pertaining to fees and expenses directly or indirectly payable by the fund and fund investors, including the following:
- 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 the adviser compensation described 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.
The SEC rationalized that such mandated disclosures would help fund investors understand and assess the cost of their private fund investments, including evaluating how much compensation is paid directly and indirectly to the adviser or its related persons, and whether such fees and expenses are charged in line with disclosures in fund offering documents.
With respect to the scope of disclosures pertaining to adviser compensation, the term “related person” would be defined as such term is defined for Form ADV and Form PF purposes and would include (i) all officers, partners or directors (or any person performing similar functions) of the adviser; (ii) all persons directly or indirectly controlling or controlled by the adviser; (iii) all current employees (other than employees performing only clerical, administrative, support or similar functions) of the adviser; and (iv) any person under common control with the adviser.
The SEC also expects fund fees and expenses to be broken down and itemized by the category of fee or expense involved, as well as the corresponding amount paid with respect to each category of fee or expense.
The Quarterly Statement Rule requires an adviser to present the dollar amount of each category of adviser compensation or fund expense before and after the application of any offsets, rebates or waivers. The SEC explained that such disclosures would help fund investors understand whether and how offsets, rebates and waivers are applied.
The Quarterly Statement Rule also requires advisers to disclose a detailed accounting of all covered 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. The term “covered portfolio investment” would only include those portfolio companies that allocated or paid the investment adviser or its related persons portfolio investment compensation during the reporting period. The requirement to disclose such portfolio investment compensation is designed to help investors evaluate any conflicts of interest associated with the receipt of such compensation by a private fund adviser or its related persons from any fund portfolio investment.
Next, as proposed, the Quarterly Statement Rule requires each statement to include prominent disclosure regarding the manner in which expenses, payments, allocations, rebates, waivers and offsets are calculated. This disclosure will generally require advisers to describe, among other things, the structure of, and the method used to determine, any performance-based compensation set forth in the quarterly statement (such as the distribution waterfall, if applicable) and the criteria on which each type of compensation is based (e.g., whether such compensation is fixed, based on performance over a certain period, or based on the value of the fund’s assets).
With respect to the quarterly statement, the SEC made clear that advisers are not limited to making the required disclosures described above – they may include additional disclosures as they deem appropriate.
As expected, the SEC expects only fund-level fee and expense disclosures and will not require individualized investor-level disclosures.
In addition to disclosures relating to fees and expenses, the Quarterly Statement Rule also requires advisers to disclose certain performance information for each fund managed. More specifically, with respect to liquid funds, the Quarterly Statement Rule requires the adviser to show performance based on net total return on an annual basis for the 10 fiscal years prior to 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, similar to the disclosures required under Rule 206(4)-1 under the Advisers Act (the “Marketing Rule”). For illiquid funds, the Quarterly Statement Rule requires advisers to show performance based on internal rates of return and multiples of invested capital since inception and to present a statement of contributions and distributions.
The SEC mandated performance disclosures to enable investors to compare private fund investments more easily, comprehensively understand their existing investments, and determine what to do holistically with their overall investment portfolio. The SEC explained that it believes that performance disclosures will decrease the likelihood that investors will be defrauded, deceived or manipulated by deceptive or manipulative representations of performance and will increase the likelihood that any misconduct will be detected sooner.
To help advisers understand which set of performance results they must disclose, the SEC defined an “illiquid fund” as a private fund that (i) is not required to redeem interests upon an investor’s request and (ii) has limited opportunities, if any, for investors to withdraw before termination of the fund. A “liquid fund” would be any private fund that is not an illiquid fund. Unfortunately, because there is no bright line as to when a liquid fund becomes an illiquid fund and vice versa, hybrid fund managers may face challenges in determining which category is appropriate for them when presenting their performance results.
Although the SEC would not generally expect quarterly statements to constitute an advertisement, it nonetheless cautioned advisers that offering their advisory services through such reports would potentially cause such a communication to become an “advertisement” subject to the substantive provisions of the Marketing Rule.
Annual Fund Audits
Rule 206(4)-10 under the Advisers Act (the “Audit Rule”) requires a registered private fund adviser to obtain an annual audit of the financial statements of any private fund it manages and to distribute them to investors in the private fund promptly after completion of the audit. The audit would need to be performed in accordance with the requirements set forth in the pooled investment vehicle audit provision found in Rule 206(4)-2 under the Advisers Act (the Custody Rule) – which means that (i) the audit must be performed by an independent public accountant that is registered with, and subject to regular inspection as of the commencement of the professional engagement period by the Public Company Accounting Oversight Board in accordance with its rules; (ii) the audit must meet the definition of audit found in Rule 1-02(d) of Regulation S-X; (iii) audited financial statements must be prepared in accordance with generally accepted accounting principles; and (iv) audited financial statements must be distributed to fund investors annually within 120 days of the private fund’s fiscal year-end (and 180 days of the fiscal year-end in the case of a fund of funds) and promptly upon liquidation of the private fund.
Prior to the adoption of the Audit Rule, private fund advisers were not required to obtain audited financial statements and to distribute them in accordance with the Custody Rule, although many private fund advisers have historically elected to obtain and distribute such audited financial statements annually to comply with the Custody Rule. Nonetheless, the SEC adopted the audit rule to make this a requirement for all advisers registered or required to register with the SEC in order to ferret out fraud perpetrated by private fund advisers, most notably with respect to the valuation of fund investments.
The SEC did, nonetheless, provide relief for advisers that are not in a control relationship with the funds they advise (e.g., sub-advisers to private funds that are not affiliated with the general partner or manager of the fund). In such circumstances, the Quarterly Statement Rule only requires that an adviser take all reasonable steps to cause its private fund client to undergo an audit that satisfies the rule when the adviser does not control the private fund and is neither controlled by nor under common control with the fund, if the private fund does not otherwise undergo such an audit.
Adviser-Led Secondaries
Rule 211(h)(2)-2) under the Advisers Act (the “Adviser-Led Secondaries Rule”) generally requires any SEC-registered adviser that offers fund investors the option between selling all or a portion of their interests in the private fund and converting or exchanging them for new interests in another vehicle advised by the adviser or any of its related persons (an “adviser-led secondary transaction”) to obtain either (i) a written opinion stating that the price being offered to the private fund for any assets being sold as part of an adviser-led secondary transaction is fair (a “fairness opinion”), or (ii) a written opinion stating the value (as a single amount or a range) of any assets being sold (a “valuation opinion”). The fairness opinion or valuation opinion must be obtained from an independent opinion provider. The adviser must also prepare and distribute a written summary of any material business relationships between the adviser or its related persons and the independent opinion provider in the two years prior to the issuance of the fairness opinion or valuation opinion. The fairness opinion or valuation opinion and the summary of material business relationships must be delivered to fund investors prior to the due date of the election form for the adviser-led secondary transaction.
The SEC believed adding these requirements was appropriate to provide fund investors with pertinent information to evaluate the adviser secondary transaction and to reduce the likelihood of fraud (e.g., through mis-valuation of assets involved in the transaction) in such transactions in light of conflicts of interest that can arise in such relation to such transactions.
Written Annual Compliance Reviews
The SEC also took the opportunity to require all registered advisers, not only private fund advisers, to memorialize the results of their annual compliance reviews, which are required to be conducted (but not currently documented) pursuant to Rule 206(4)-7 under the Advisers Act (the “Compliance Rule”). The SEC reminded advisers that the annual compliance review should consider any compliance matters that arose during the previous year, any changes in the business activities of the adviser or its affiliates, and any changes in the Advisers Act or applicable regulations that might suggest a need to revise the adviser’s policies and procedures. The SEC indicated in the proposing release that documentation of the annual review is necessary to help the examination staff understand an adviser’s compliance program, determine whether the adviser is complying with the Compliance Rule and to identify potential weaknesses in the adviser’s compliance program.
With the passage of the amended Compliance Rule, such annual compliance reviews must now be documented, although the SEC did not specify the format for documentation of such annual compliance reviews. For instance, in the proposing release, the SEC recognized that some advisers conduct reviews quarterly, and any reports generated as a result of such quarterly reviews could be compiled together in order to meet the annual compliance review documentation requirement.
Rules That Impact All Private Fund Advisers
Although the rules described above only impact advisers registered with the SEC, certain of the adopted rules impact all private fund advisers, regardless of whether they are registered with the SEC. Below we highlight those rules and the impact they will have on such private fund advisers. Some of the rules adopted flatly prohibit certain types of conduct while other rules simply restrict certain types of conduct unless disclosure and, in some cases, other requirements are satisfied. Below is a summary of these rules and the impact they will have on private fund advisers.
Prohibited Activities
Rule 211(h)(2)-3 under the Advisers Act (the “Preferential Treatment Rule”) prohibits a registered adviser from providing certain types of preferential treatment to some but not all investors. Among other things, the Preferential Treatment Rule prohibits an adviser from granting an investor in the private fund or in a similar pool of assets 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 or in a similar pool of assets except where (i) for redemptions required by applicable law, rule, regulation or order of certain governmental authorities or (ii) if the adviser has offered the same redemption ability to all existing investors and will continue to offer the same redemption ability to all future investors in the private fund or similar pool of assets. The Preferential Treatment Rule defines a “similar pool of assets” as a pooled investment vehicle (other than an investment company registered under the Investment Company Act of 1940 or a company that elects to be regulated as such) with similar investment policies, objectives or strategies to those of the private fund managed by the adviser or its related persons. The Preferential Treatment Rule is designed to address conflicts of interest associated with an adviser granting preferential liquidity terms to certain investors that could result in investments that increase the adviser’s overall compensation.
With respect to preferential redemption rights, the SEC’s concern is that those without preferential redemption rights could experience serious harm as a result of the granting of preferential redemption rights to select investors in certain circumstances. For example, if an adviser allows a preferred investor to exit the fund early and sells liquid assets to accommodate the preferred investor’s redemption, the fund may be left with a less liquid pool of assets, which can inhibit the fund’s ability to carry out its investment strategy or promptly satisfy other investors’ redemption requests. This can make it more difficult for remaining investors to mitigate their investment losses when there is a market downturn.
The Preferential Treatment Rule also prohibits an adviser from providing preferential information rights to certain investors such that those investors would receive enhance information relating to portfolio holdings and/or exposures of the private fund or a similar pool of assets if the adviser reasonably expects that providing the information would have a material, negative effect on other investors in that private fund or in a similar pool of assets, except where the adviser offers such information to all other existing investors in the private fund and any similar pool of assets at the same time or substantially the same time. The SEC rationalized that disclosure of such arrangements would not be sufficient to mitigate the resulting conflicts of interest that could result in certain investors being able to profit (or avoid losses) when provided such portfolio information, including the ability to engage in front running of the fund when armed with such information.
The new rule would also require advisers that provide other types of treatment to certain fund investors to provide written disclosures to prospective and current investors in the private fund regarding such arrangements. Prospective investors must be provided with information relating to material economic terms relating to such preferential terms before they invest in the fund. Advisers must also distribute to current fund investors a written notice of all preferential treatment the adviser or its related persons has provided to other investors in the same private fund (i) for an illiquid fund, as soon as reasonably practicable following the end of the fund’s fundraising period and (ii) for a liquid fund, as soon as reasonably practicable following the investor’s investment in the private fund. Advisers must also provide existing fund investors with comprehensive, annual disclosure of all preferential treatment provided by the adviser or its related persons since the last notice was provided to such fund investors.
Restricted Activities
Rule 211(h)(2)-1 under the Advisers Act (the “Restricted Activities Rule”) restricts advisers to a private fund 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 or its related persons by any governmental or regulatory authority; however, regardless of any disclosure or consent, an adviser may not charge or allocate fees and 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 or the rules promulgated thereunder;
- Charging the private fund for any regulatory, examination or compliance fees or expenses of the adviser or its related persons;
- Reducing the amount of any adviser clawback by actual, potential or hypothetical taxes applicable to the adviser, its related persons or their respective owners or interest holders;
- Charging or allocating fees and expenses related to a portfolio investment on a non-pro rata basis when more than one private fund or other client advised by the adviser or its related persons have invested in the same portfolio company; and
- Borrowing money, securities or other private fund assets, or receiving a loan or extension of credit, from a private fund client.
The following is a more detailed description of each of these restrictions:
First, advisers would be prohibited from charging or allocating to fund investors any regulatory, examination or compliance fees or expenses of the adviser or its related persons unless the adviser distributes a written notice of any such fees or expenses (broken down by category), and the dollar amount thereof, to investors in a private fund in writing on at least a quarterly basis. The SEC reasoned that advisers should not be passing along certain expenses attributable to the adviser’s operations unless there is full and fair disclosure of any such expenses charged to the fund. Advisers may, but are not required to, provide such disclosures in the quarterly statement mandated to be provided by SEC-registered advisers.
Second, advisers would not be permitted to 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 adviser distributes a written notice to the investors of the impacted private fund client that sets forth the aggregate dollar amounts of the adviser clawback both before and after any such reduction of the clawback for actual, potential or hypothetical taxes within 45 days after the end of the fiscal quarter in which the adviser clawback occurs. For purposes of the rule, the term “adviser clawback” is defined as any obligation of the adviser, its related persons, or their respective owners or interest holders to restore or otherwise return performance-based compensation to the private fund pursuant to the private fund’s governing agreements. This typically occurs where an adviser receives outsized performance-based compensation in the early stages of a fund’s life, but is required to return a portion of any performance-based compensation previously earned if later investments do not perform as well as earlier investments, which would result in a windfall to the adviser absent the adviser clawback obligation.
The SEC imposed this restriction and disclosure requirement because the staff believes that most fund investors are not sufficiently aware of the negative impact that taxes have on the turn of any adviser clawback obligation. Advisers may, but are not required to, provide such disclosures in the quarterly statement mandated to be provided by SEC-registered advisers.
Third, an adviser would be prohibited from directly or indirectly charging or allocating fees and 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 adviser ensures that any such allocation is fair and equitable under the circumstances and (ii) before charging or allocating such fees or expenses to a private fund client, the adviser distributes to each investor a written notice of the non-pro rata charge or allocation and a description of how (and ideally why) it is fair and equitable under the circumstances.
The SEC mandated such requirements to prevent advisers from allocating expenses across funds in a manner designed to promote its own interest at the expense of certain fund investors. The SEC believes that implementation of these additional safeguards will mitigate the likelihood that advisers will favor certain funds over others in the allocation of expenses and provide fund investors with clarity as to how the adviser’s expense allocation practices impact the fund investor.
Fourth, advisers would be prohibited from charging or allocating to fund investors fees and expenses associated with an investigation of the adviser or its related persons by any governmental or regulatory authority unless the adviser seeks consent from all investors of a private fund, and obtains written consent from at least a majority in interest of the fund’s investors that are not related persons of the adviser.
Unlike with respect to other expenses to be charged or allocated to fund investors, the SEC believes that obtaining investor consent to the charging of adviser-related investigation expenses is appropriate because such investigations are focused on the adviser’s own potential or actual wrongdoing and, absent imposition of the investor consent requirement, an adviser would have adverse incentives to engage in conduct likely to trigger an investigation and may not be adequately incentivized to limit the legal fees incurred on its own behalf in the course of an investigation.
Nonetheless, an adviser would not be permitted to charge a fund for 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 its rules, with or without consent from investors. This could, therefore, result in refunding of fees initially advanced by the fund to cover investigation-related expenses where an adviser is ultimately found to have violated the Advisers Act or its rules.
Finally, advisers would be prohibited from borrowing money, securities or other fund assets, or receiving a loan or an extension of credit, from a private fund client unless the adviser distributes a written notice and description of the material terms of the borrowing to the investors of the private fund, seeks their consent for the borrowing, and obtains written consent from at least a majority in interest of the fund’s investors that are not related persons of the adviser. The SEC reasoned that the conflicts of interest associated with borrowing transactions could result in significant harm to fund investors without the requirement to obtain consent to such transactions from fund investors.
Amendments to the Books and Records Rule
Amendments to Rule 204-2 under the Advisers Act (the “Books and Records Rule”) require investment advisers to private funds to make and keep records relating to the quarterly statements required under the Quarterly Statement Rule, the financial statement audits performed under the Audit Rule, disclosures regarding restricted activities provided under the Restricted Activities Rule, fairness opinions or valuation opinions required under the Adviser-Led Secondaries Rule, and disclosure of preferential treatment required under the Preferential Treatment Rule.
Proposed Rules Not Adopted
The SEC declined to adopt certain rules proposed in the Proposing Release. Even though such rules were not adopted, the SEC nonetheless believes that the practices underlying such rule proposals present concerns, and advisers should be cautioned not to engage in such practices despite the absence of formal rules prohibiting such conduct. The following are some of the rules that were not adopted and the impact that this will have on advisers.
First, the SEC declined to adopt a proposed prohibition on charging a portfolio investment for monitoring, servicing, consulting or other fees in respect of any services the investment adviser does not, or does not reasonably expect to, provide to the portfolio investment, such as situations involving a change of control that requires acceleration of payments owed to the adviser despite services not having been performed.
The SEC ultimately determined that adopting rules prohibiting such conduct are unnecessary because such conduct is inconsistent with an adviser’s fiduciary duty of care and duty of loyalty to investors, thus making a rule prohibiting such conduct unnecessary and duplicative.
Therefore, despite the lack of a specific rule prohibiting charging fund investors for services that are not performed, advisers should refrain from charging fund investors such fees as this is likely to be a focus area for the SEC in future examinations of private fund advisers.
Second, the SEC declined to adopt a proposed rule that would have prohibited a private fund adviser from seeking reimbursement, indemnification, exculpation from or limitation of its liability to the private fund or its investors for a breach of fiduciary duty, willful misfeasance, bad faith, negligence or recklessness in providing services to the private fund. The SEC reasoned that the rule was not necessary because such clauses could already be evaluated based on whether they violate the antifraud provisions contained in the Advisers Act and the adviser’s existing fiduciary duty owed to the funds they advise.
The SEC provided some context to help private fund advisers evaluate whether such clauses could violate their fiduciary duty owed to clients. First, the SEC reminded private fund advisers that the scope of the adviser’s fiduciary duty owed to their fund clients depends on what functions the adviser, as agent, has agreed to assume for the fund client. The SEC also reiterated that an adviser’s fiduciary duty of loyalty to fund clients may differ from the fiduciary duty owed to retail clients because full and fair disclosure for an institutional client (including the specificity, level of detail, and explanation of terminology) can differ, in some cases significantly, from full and fair disclosure for a retail client because institutional clients generally have a greater capacity and more resources than retail clients to analyze and understand complex conflicts and their ramifications.
With this backdrop in mind, the SEC explained that whether a hedge clause found in fund offering documents violates an adviser’s fiduciary duties to its fund client would depend on the circumstances. To provide more context, the SEC provided examples where such clauses would be deemed to violate an adviser’s fiduciary duty to its fund clients. Among other things, a clause that explicitly or generically waives the adviser’s federal fiduciary duty to clients without a “savings clause” indicating that the fund is not waiving unwaivable rights under the Advisers Act would be deemed to violate the adviser’s fiduciary duty to its clients. Similarly, the SEC noted that it would be inconsistent with an adviser’s fiduciary duty for an adviser to 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 Advisers Act.
For the most part, the SEC’s commentary in the Adopting Release should represent relatively good news for private fund advisers because most advisers do include in their exculpation and indemnification provisions clauses clarifying that the funds they advise are not giving up rights that they are not permitted to waive under the federal securities laws.
Nonetheless, advisers should carefully evaluate the exculpation and indemnification provisions in their fund offering documents to determine whether such provisions make sufficiently clear that fund investors are not giving up rights that cannot be waived under the federal securities laws.
Compliance Dates
With respect to the Audit Rule and the Quarterly Statement Rule, the SEC will require compliance with such rules within18 months after the rules become effective.
For the Adviser-Led Secondaries Rule, the Preferential Treatment Rule and the Restricted Activities Rule, the SEC set compliance dates based on the amount of private fund assets under management of an adviser as follows:
- For advisers with $1.5 billion or more in private funds assets under management (larger private fund advisers), compliance is required within 12 months of the effective date of the rule; and
- For advisers with less than $1.5 billion in private funds assets (smaller private fund advisers), is required within 18 months of the effective date of the rule.
Compliance with the amended Advisers Act Compliance Rule will be required as of the effective date of the rule.
Rules will become effective within 60 days of publication in the Federal Register.
Legacy Status
As many advisers were concerned that the new rules would require advisers to amend existing contractual arrangements and/or offering documents with respect to existing funds, the SEC provided relief such that advisers’ arrangements with existing funds would not be subject to the Preferential Treatment Rule or the restrictions on advisers borrowing from a private fund and the restriction from charging funds for certain investigation fees and expenses contained in the Restricted Activities Rule. However, the SEC would still require advisers to obtain consent from investors in existing funds prior to charging funds for 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 its rules.
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