On August 23, 2023, the US Securities & Exchange Commission (SEC) adopted new and amended rules (the New Rules) under the Investment Advisers Act of 1940 (Advisers Act) that focus on the SEC’s desire to address what it views to be “risks and harms that are common in an adviser’s relationship with private funds and their investors.” Throughout this article, we will summarize the New Rules, explore their effect on investment advisers to private funds and highlight some of the SEC’s stated views in the adopting release.

Our discussion of the New Rules has been separated into five parts:

1. The Restricted Activities prohibit some practices unless certain consent or disclosure obligations are met (walking back many outright prohibitions sought in the rule proposal).
2. Preferential Treatment restrictions and disclosure obligations, which are generally designed to address side letter arrangements favoring certain private fund investors.
3. The obligations of advisers to send Quarterly Statements to investors.
4. Requirements for advisers when undertaking Adviser-Led Secondaries.
5. The Mandatory Audits provision for private funds and the Written Annual Review requirement to document annual compliance reviews under Rule 206(4)-7.

The New Rules also add books and records requirements to document compliance.

IN DEPTH

APPLICABILITY TO REGISTERED INVESTMENT ADVISERS AND OTHER ADVISERS

The New Rules will apply to all investment advisers registered or required to be registered with the SEC under the Advisers Act, however, the New Rules covering Restricted Activities and Preferential Treatment will apply to any investment adviser, including exempt reporting, state-exempt and registered advisers (e.g., venture capital advisers, small private fund managers and certain US domiciled private funds of non-US-based investment advisers). Persons excluded from the definition of investment adviser will not be affected, such as advisers who meet the “family office” or “bank” exclusions. “Securitized asset funds,” any private fund whose primary purpose is to issue asset-backed securities and whose investors are primarily debt holders are excluded from the New Rules except for the Written Annual Review requirement.

COMPLIANCE DATES

• Mandatory Audits and Quarterly Statements – 18 months

• Restricted Activities, Preferential Treatment and Adviser-Led Secondaries
  • 12 months for advisers with $1.5 billion or more in private funds assets under management
  • 18 months for all other advisers
• Written Annual Review – 60 days[1]

RESTRICTED ACTIVITIES

Investigation Fees and Expenses

Investment advisers are not permitted to allocate fees and expenses to private funds in connection with any investigation by a regulatory or governmental authority unless the adviser has consulted with all investors of a private fund and has obtained the prior written consent from at least a majority in interest of such private fund’s investors. Consent must be specifically granted by a majority in interest of non-investment adviser-related investors. Consent granted by an investor advisory committee will be insufficient under the rule.

However, should any Advisers Act sanctions be implemented against the adviser as a result of an investigation, the adviser is prohibited from charging such investigation fees and expenses. Advisers in these circumstances would need to reimburse the private fund for any such fees or expenses for which they previously obtained consent.

Grandfathering. For any private funds commencing operation prior to the applicable compliance date, the required consent is not required for charging investigation fees and expenses to the private fund so long as the private fund contractual agreements were in place prior to the compliance date and would require the parties to amend the agreement in order to comply. This grandfathering provision does not apply to investigations resulting in Advisers Act sanctions.

Compliance, Regulatory and Examination Fees and Expenses

The New Rules prohibit all investment advisers to private funds from charging certain fees or expenses related to the compliance, regulatory and examinations fees and expenses (including the cost of hiring a compliance consultant and legal fees) of the adviser unless the adviser provides written notice to all private fund investors of any such fees and expenses, including the dollar amount, within 45 days from the end of the fiscal quarter in which the charge occurs. We would typically expect this to be disclosed along with the required Quarterly Statements for registered investment advisers, however, there is a disconnect between the year-end statement time and the requirements for fund of funds Quarterly Statements, which would increase the disclosure burdens.

Investment Adviser Tax Clawback Reductions

Under the New Rules, an adviser is restricted from reducing the amount of an adviser-carried interest clawback requirement for a private fund by actual, potential or hypothetical taxes applicable to the adviser, its affiliates or their respective owners or interest holders unless the adviser provides written notice to the investors of the private fund within 45 days from the end of the fiscal quarter in which the adviser clawback occurs, setting forth the aggregate pre-tax and post-tax dollar amounts of its clawback. Most registered investment advisers will generally be able to include these amounts along with the required Quarterly Statements, except in the case of the timing mismatch for the year-end statement and requirements for fund of funds.

Non-Pro Rata Fee and Expense Allocations

The New Rules also prohibit an adviser from directly or indirectly charging or allocating fees or expenses related to a portfolio investment on a non-pro rata basis among all participating private funds and other clients advised by the adviser unless (i) the non-pro rata charge or allocation is fair and equitable under the circumstances and (ii) prior to charging or allocating such fees or expenses to a private fund, the adviser provides written notice to each investor of the non-pro rata charge or allocation along with a description of how the allocation approach is fair and equitable under the circumstances. The SEC did not explain what a fair and equitable but non-pro rata distribution might be, leaving it to a facts and circumstances analysis that should be documented by the adviser.

Borrowing

Advisers are prohibited under the New Rules from directly or indirectly borrowing money, securities or other fund assets or receiving any loan or extension of credit from an advised private fund unless the adviser (i) provides prior written notice to each fund investor (including a description of the material terms of the proposed borrowing, loan or extension of credit) and (ii) obtains written consent from at least a majority in interest of the private fund’s non-adviser-related investors. Investor advisory committees are not able to provide this consent.

Grandfathering. For any private funds commencing operation prior to the applicable compliance date, the required disclosure and consent are not required so long as the private fund contractual agreements (and the contractual arrangements governing the borrowing), were in place prior to the compliance date and would require the parties to amend the agreement in order to comply.

Proposed Rules Not Adopted

The SEC declined to adopt the rule proposal that would have prohibited advisers from seeking indemnification or otherwise limiting the adviser’s liability for its breach of fiduciary duty, willful misfeasance, bad faith, negligence or recklessness in providing services to the private fund. The SEC explained that it believed such a provision was not necessary because of the federal fiduciary duties, which apply to investment advisers. The adopting release discussed the SEC’s long-standing position that advisers cannot waive their federal fiduciary duties and that contract provisions, which “generically” waived such duties, could be a breach. The release raises some questions about how the SEC may view private fund contractual agreements in light of the change from the proposed rule.

The proposed rule also prohibited charging private funds for unearned compensation, but it was not included in the New Rules. The SEC based this decision on comment letters suggesting that such practices had largely been eliminated and its view that charging fees for unperformed services was a breach of fiduciary duty. The discussion in the release raises questions about how the SEC will apply fiduciary duties in these cases outside of existing enforcement cases.

PREFERENTIAL TREATMENT

Favorable Redemption Rights

The SEC’s new Rule 211(h)(2)-3 prohibits any investment adviser from providing favorable redemption rights to any investor that the adviser reasonably expects to have a material, negative effect on other investors in that private fund except in the case of a redemption right required by applicable law governing the investor or the fund, or if the adviser offers the same redemption rights to all existing and future investors in the private fund. This does not apply to any rights provided to substantially similar pooled investment vehicles managed by the adviser. This restriction is clearly directed at hedge fund (or other funds offering periodic redemptions) practices giving better redemption terms to certain investors to obtain investments from larger and/or strategic investors. The effect on redemption right practices (generally the lack thereof except for legal requirements) for most private equity and other closed-end funds is likely to be minimal.

Grandfathering. For any private funds commencing operation prior to the applicable compliance date, the restrictions do not apply so long as the private fund contractual agreements were in place prior to the compliance date and would require the parties to amend the agreement in order to comply.

Favorable Information Rights

Advisers are also prohibited from providing favorable information rights regarding portfolio holdings or exposures to any investor that the adviser reasonably expects to have a material, negative effect on other investors in that private fund except when the adviser offers the same redemption rights to all existing and future investors in the private fund (including substantially similar pooled investment vehicles). Information disparity is a clear concern for the SEC for private funds permitting periodic redemption because investors need information to make their investment decision on when or how much to redeem from a fund.

With the new Quarterly Statements requirement, some of the SEC’s risks (and requests from investors) should be mitigated as advisers will be required to disclose commonly requested information on a periodic basis. However, the SEC declined to provide any exceptions for oral communications, citing the material, negative effect standard as sufficient to provide freedom in discussing investments with investors. Advisers will need to be careful in publicly discussing their fund investments, even during fund investor meetings, as all investors may not be in attendance. The SEC further declined to exclude closed-end funds from the rule because some such funds may offer redemption rights in certain extraordinary circumstances and cite security market integrity when certain investors may learn information about a specific portfolio company.

Grandfathering. For any private funds commencing operation prior to the applicable compliance date, the restrictions do not apply so long as the private fund contractual agreements were in place prior to the compliance date and would require the parties to amend the agreement in order to comply.

Preferential Treatment Generally

The New Rules do not allow any type of preferential treatment for any private fund investors unless the adviser (i) provides any prospective investor with written notice describing any preferential treatment related to any material economic terms that the adviser provides to other investors in a private fund (or substantially similar pool) prior to the prospective investor’s investment in the private fund and (ii) provide all investors with written notice of all preferential treatment the adviser has provided to other investors in the fund. For an “illiquid fund” (investors cannot redeem upon request and opportunities to redeem prior to termination are limited), notice must be provided as soon as reasonably practicable following the end of the fund’s fundraising period and on an annual basis thereafter if any new preferential terms have been provided to investors since the prior notice. For a “liquid fund,” notice must be provided as soon as reasonably practicable following the investor’s investment in such private fund and annually thereafter if new preferential treatment is provided.

The SEC, however, does not define “preferential treatment,” provide any materiality qualifier nor address whether preferential treatment, in this case, was limited to preferential treatment in written agreements with investors (portions of the adopting release refer to “granting” preferential treatment yet the rule used the term “provide” and the release states that preferential treatment can be “provided through various means, including side letters”). When discussing oral statements in the restriction on favorable information rights, the SEC declined exceptions because it believes the material, negative effect standard alleviated concerns that investor communication would be stifled. This provision includes disclosure of “all” direct or indirect preferential treatment, which could include discussions with some investors and not others or any number of activities that not all investors may participate in (such as activities at investor meetings or business meals and entertainment).

QUARTERLY STATEMENTS

The SEC’s new Rule 211(h)(1)-2 requires that any SEC-registered investment adviser (including those that are required to be registered) providing investment advice to a private fund must prepare and distribute a quarterly statement to the private fund investors. The statement must include specified information regarding fees and expenses paid or allocated to the private fund or portfolio companies, along with fund and portfolio company performance, and should be presented in a table format with specific line items for certain types of expenses.

Additionally, quarterly statements prepared for illiquid funds will have to show Gross and Net IRR and MOIC at the fund level as well as Gross IRR and MOIC (each as defined specifically in the New Rules) for each realized and unrealized portfolio investment. Liquid funds are required to provide net total and average returns for the fund over specified periods. Additionally, all statements, regardless of private fund type, must include prominent disclosures with respect to the values of and applicable calculation methodology on how expenses, payments, allocations, rebates, waivers and offsets are calculated. The rule also contains requirements for consolidating the reporting for similar funds.

Quarterly statements must be provided to investors in private funds (other than funds of funds) no later than 45 days from the end of each of the first three quarters of the fiscal year and within 90 days from the end of each fiscal year. For funds of funds, quarterly statements must be provided no later than 75 days from the end of each of the first three quarters of the fiscal year and within 120 days from the end of each fiscal year.

ADVISER-LED SECONDARIES

When an SEC-registered investment adviser offers existing fund investors the choice between selling some or all of their interests in a private fund or converting or exchanging some or all of their interests in the private fund for interests in another vehicle advised by the adviser or any affiliate thereof, the adviser will be required to provide all investors with either a fairness opinion or a valuation opinion from an independent opinion provider prior to their decision. Advisers will also be required to provide a summary to investors identifying any business relationships with the opinion provider in the past two years. We note that the rule excludes tender offers from the scope of adviser-led secondary transactions.

MANDATORY AUDITS AND WRITTEN ANNUAL REVIEW

New Rule 206(4)-10 requires all SEC-registered investment advisers to cause the private funds they advise (other than securitized asset funds) to undergo independent audits and distribute the audited financial statements in accordance with the audit exception provision under the Advisers Act custody rule (Rule 206(4)-2). The rule essentially removes the audit requirement from the constraints of the custody rule by including a provision that if an investment adviser provides investment advice to a private fund and does not control and is neither controlled by nor under common control with the private fund, the adviser must take all reasonable steps to cause the private fund to undergo an audit and affect the distribution of such audited financial statements. The New Rules are likely to require audits of private funds in scenarios where the adviser does not have custody of the private fund assets, including the use of unregistered investment advisers (such as non-US managers or bank trustees) as general partners, managing members or trustees. The SEC declined to give specific examples of reasonable steps.

Finally, the SEC amended Rule 206(4)-7 to require that SEC-registered investment advisers document in writing the annual review historically required by the rule.

Associate Rafael Calatrava also contributed to this article.

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