Key takeaways

• The SEC adopts a final rule presenting sweeping changes to the U.S. private funds industry.
• The final rule adopts an investor disclosure and consent model to many practices, backing off of prior proposals that would have imposed blanket prohibitions, including carried interest clawbacks net of taxes; non-pro rata allocation of expenses among funds; borrowing arrangements with private fund clients; and indemnification and reimbursement provisions relating to certain regulatory exams, investigations and enforcement proceedings.
• In addition, the final rule will impose substantial additional reporting and recordkeeping requirements on investment advisers that are registered with the SEC.

Overview:
On August 23, 2023, the Securities and Exchange Commission (the “SEC”) approved by a 3-2 vote a final rule enacting a series of wide-sweeping changes to the regulation of the private funds industry (the “Final Rule”). While the Final Rule makes several concessions from the form originally proposed on February 9, 2022, the Final Rule imposes substantial new recordkeeping, reporting and disclosure requirements, imposes new investor consent requirements, and in some cases outright prohibits several current industry practices. 

The Final Rule requires investment advisers that are registered under the Investment Advisers Act of 1940 (the “Advisers Act”) and managing one or more private funds to:

• provide investors in private funds with quarterly statements detailing information about the fund’s performance, fees and expenses;
• obtain an annual audit, by a PCAOB registered and inspected audit firm, for each private fund it advises and cause the private fund’s auditor to notify the SEC upon certain events; and
• distribute to investors, in connection with any adviser-led secondary transaction, a fairness opinion or a valuation opinion, and a written summary of certain material business relationships between the adviser and the opinion provider.

The Final Rule also requires all SEC registered investment advisers, whether or not managing any private funds, to document the annual review of their compliance policies and procedures.

In addition, the Final Rule sets forth the following prohibitions, which apply to all investment advisers to private funds, whether or not registered with the SEC (including exempt reporting advisers and state registered investment advisers):¹

• charging fees or seeking reimbursement for expenses associated with a governmental or regulatory examination or investigation without investor disclosure (on a quarterly basis, detailing any such expenses) and consent; or, regardless of any disclosure or consent, charging such fees relating to an investigation that results in a sanction for violating the Advisers Actor the rules thereunder; 
• reducing any carried interest clawback for related taxes without certain disclosures (including the amount of such clawback with and without such reduction) to investors and their informed consent;
• non-pro rata² allocations of portfolio investment related expenses among multiple private funds or other clients that are invested in such portfolio investment, unless (i) such allocation is fair and equitable under the circumstances, and (ii) the adviser first notifies each investor in a private fund receiving a non-pro rata allocation of the amount of the allocation and explains how it is fair and equitable under the circumstances;
• borrowing from a private fund client, unless the investment adviser provides advance notice of the borrowing’s material terms and obtains consent from a majority in interest of the private fund’s investors (excluding any related persons of the adviser);
• providing to private fund investors the preferential treatment described below, if the adviser reasonably expects it will have a material, negative effect on other investors in the fund or investors in any similar pool of assets:
  1. preferential redemption rights (other than as required to comply with applicable law, rules, regulations or government orders), unless such rights are offered to other existing investors in such private fund or similar pool or assets and will continue to be offered to other future investors without qualification (including as to commitment size, affiliation or otherwise); and
  2. preferential information rights, unless the adviser provides such information to all investors at the same time or substantially the same time;³ and
• granting to any investor in a private fund any other type of preferential treatment without disclosure. Disclosure of material preferential economic terms must be made to a prospective private fund investor prior to its investment, with remaining preferential terms to be disclosed following the investment (either as soon as reasonably practicable thereafter, for a liquid fund, or following the termination the fund’s offering, for an illiquid fund). Notice of any new preferential treatment granted to private fund investors since the last notice must be made annually to all existing investors.

The Final Rule does not adopt the proposed prohibition on charging portfolio investments for monitoring, servicing, consulting, or other fees in respect of any services that the investment adviser does not, or does not reasonably expect to, provide. However, the release notes that such activity would be a breach of the adviser’s fiduciary duty.

To ensure compliance with the Final Rule, the SEC adopted amendments to Adviser Act’s books and records rule requiring registered investment advisers to retain records related to the Final Rule, including records relating to quarterly statements, audited financial statements, adviser-led secondaries, and notices of preferential treatment. 

The compliance dates for the provisions of the Final Rule relating to preferential treatment, adviser-led secondaries, and restricted activities are staggered based on the adviser’s private fund assets under management (“PFAUM”), with a 12-month transition period (from the effective date of the Final Rule) for advisers having a PFAUM of $1.5 billion or greater and an 18-month transition period for advisers having a PFAUM below this threshold. All advisers will have an 18-month transition period to implement the provisions relating to quarterly statements and audited annual financial statements. The requirement to document annual reviews of compliance policies and procedures will take immediate effect on the effective date of the Final Rule, which will be 60 days following its publication in the Federal Register.

Existing private funds have been granted legacy status as to the Final Rule’s prohibitions on preferential treatment and the aspects of its restricted activities that require investor consent, but only to the extent that governing documents (including side letters) entered into prior to the applicable compliance date of the Final Rule would require amendment to comply with the terms of the Final Rule. Legacy status does not extend to the required disclosure of preferential terms granted by a private fund prior to the applicable compliance date; accordingly, such terms will be required to be disclosed in accordance with the Final Rule to any investor investing in the fund following the compliance date.
 
 

¹The release notes that the bulk of the Final Rule’s provisions do not apply to an investment adviser without a place of business in the United States, regardless of registration or exempt reporting adviser status, with respect to such adviser’s offshore clients (including any offshore private fund, even if it has U.S. investors).

²The SEC declined to define how pro rata must be calculated for purposes of the above prohibition.

³In adopting this prohibition, the SEC notes that the ability to redeem ahead of other investors is an important consideration in determining whether preferential information rights should be reasonably expected to have a material, negative effect on other private fund investors, but did not limit the prohibition to open-ended funds.