The United States Securities and Exchange Commission recently adopted sweeping changes to the regulatory regime that governs private investment funds – hedge funds and private equity funds. The Aug. 23, 2023, changes are the most dramatic since the SEC implemented rules under the Dodd-Frank Wall Street Reform Act of 2010 (Dodd-Frank Act) that require most, but not all, advisers to private funds to register under the Investment Advisers Act of 1940 (IAA).

The new rules – already being challenged in court -- seek to enhance transparency and investor protection by imposing constraints on the operational practices of private funds and imposing new disclosure requirements.

Unlike mutual funds registered under the Investment Company Act of 1940 (ICA), private funds are structured to rely on an exemption from registration under the ICA and, as such, are not subject to the complex ICA regulatory regime. Most, but not all, sponsors of private funds are registered investment advisers regulated at the federal level under the IAA. Other sponsors include exempt reporting advisers, e.g., advisers to venture capital funds. Because private funds had been subject to limited regulatory oversight prior to the adoption of the new rules, their sponsors have historically enjoyed enormous flexibility in managing these funds. However, in comparison to investors in registered funds, many investors in private funds have enjoyed little transparency.

Contemporaneously with the adoption of the new rules under IAA, a press release quoted Gary Gensler, chairman of the SEC, as saying: “Private funds and their advisers play an important role in nearly every sector of the capital markets…by enhancing advisers’ transparency and integrity, we will help promote greater competition and thereby efficiency. Consistent with our mission and Congressional mandate, we advance today’s rules on behalf of all investors — big or small, institutional or retail, sophisticated or not.”

How the New Rules Affect Private Fund Advisers

The final rules will:

• Require private fund advisers registered with the SEC to provide investors with quarterly statements detailing certain information regarding fund fees, expenses and performance.
• Require a private fund adviser registered with the SEC to obtain and distribute to investors an annual financial statement audit of each private fund it advises and, in connection with an adviser-led secondary transaction, a fairness opinion or valuation opinion.
• Prohibit all private fund advisers from providing investors with preferential treatment regarding redemptions and information if such treatment would have a material, negative effect on other investors.
• Require specified disclosures to all current and prospective investors in all other cases of preferential treatment; and
• Restrict certain other private fund adviser activities that are contrary to the public interest and the protection of investors.

To avoid requiring advisers and investors to renegotiate governing agreements for existing funds, the SEC adopted legacy status provisions applicable to a certain number of the restricted activities and preferential treatment provisions. The legacy status will apply to those governing agreements entered into in writing prior to the compliance date and with respect to funds that have commenced operations as of the compliance date.

The ambitious reform package includes amendments to the compliance program rule under the IAA requiring 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 new rules were published in the Federal Register on September 14, 2023, and will go into effect on November 13, 2023. Compliance deadlines vary depending on the specific requirements and, in some cases, on the size of the private fund adviser, as measured by assets under management.

Legal Challenges to the New Rules

On September 1, 2023, six trade associations asserted legal challenges to the Private Fund Adviser Rules adopted just nine days earlier. In their Petition for Review filed in the Unites States Court of Appeals for the Fifth Circuit, the petitioners allege that “the rules were adopted without compliance with notice-and-comment requirements, and are otherwise arbitrary, capricious, an abuse of discretion and contrary to law, all in violation of the Administrative Procedure Act, 5 U.S.C. § 706, and of the Commission’s heightened obligation to consider its rules’ effects on efficiency, competition and capital formation 15 U.S.C. § 80b-2(c).” The petition contends the new rules would fundamentally change the way private funds are regulated in America and requests that the court “vacate and set aside the rules.” The filing of the Petition for Review does not, however, pause the rules.

Assuming the new rules survive the challenge asserted by the six trade organizations, implementation of the rules is likely to improve the investment experience of investors in these private funds. For example, the annual audit requirement will provide greater assurance that valuations assigned to the individual portfolio securities are well-founded. Nevertheless, Chairman Gensler’s optimistic vision for the new paradigm, that the new rules are being advanced on behalf of all investors — “big or small, institutional or retail, sophisticated or not” may not be well-founded.