Today, the Securities and Exchange Commission adopted new and amended rules under the Investment Advisers Act of 1940, as amended (Final Rules) that will significantly reform the scope of reporting, disclosure and other obligations imposed on investment advisers to private funds (Private Fund Advisers).¹ The Final Rules represent the most significant changes to the regulation of private funds and Private Fund Advisers since the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The Final Rules include five major components:

• Requirements to distribute quarterly statements;
• Audit requirements;
• Conditions to adviser-led secondaries;
• Restrictions on certain activities, including recouping some expenses and borrowing arrangements with funds; and
• Restrictions on preferential treatment.

Many of the most contentious provisions in the February 2022 rule proposal² were omitted or significantly revised in the Final Rules, including the proposed prohibitions on limiting a Private Fund Adviser's liability for certain misconduct, and charging fees for services that have not been or are not expected to be performed by the Private Fund Adviser. The Final Rules also allow Private Fund Advisers to engage in certain other activities that would have been prohibited under the original proposal, subject to additional disclosure and consent requirements, as further discussed below. The Final Rules also grandfather some existing practices, meaningfully reducing the implementation burden for funds operating ahead of the compliance date. Notwithstanding these changes, the Final Rules will impose significant compliance burdens and alter the relationship between investors and Private Fund Advisers in many respects.

Investment Advisers Subject to the Rule

As described below, the quarterly statement, private fund audit, and adviser-led secondaries rules apply only to SEC-registered Private Fund Advisers (Private Fund RIAs), while the restricted activities and preferential treatment rules apply to all Private Fund Advisers regardless of registration status.

Moreover, certain private funds are entirely exempt from the five substantive private fund adviser rules (the Private Fund Adviser Rules). The adopting release clarifies that the rules do not apply to offshore advisers (regardless of SEC registration status) with respect to offshore funds, even if those offshore funds have U.S. investors. 

In a significant change from the proposal, the SEC also added an exception from the Private Fund Adviser Rules for “securitized asset funds,” which generally include collateralized loan obligations (CLOs).

Private Fund Adviser Rules Applicable to Private Fund RIAs:

Quarterly Statements. The Final Rules require Private Fund RIAs to distribute quarterly statements to private fund investors that include:

• A “fund table” with a detailed accounting of all compensation paid or allocated to the adviser and related persons, fund fees and expenses, and any fee offsets or rebates during the reporting period.
• A “portfolio investment table” that includes a detailed accounting of all compensation paid or allocated by a private fund’s portfolio investments to the adviser.
• Expense calculation disclosures, including the methodology used by the adviser to calculate fund fees and expenses, with cross references to the relevant provisions in the fund’s offering documents that contain the calculation methodology.
• Standardized performance information, the form and content of which will vary depending on whether the fund is “liquid” or “illiquid.”

Private Fund RIAs should be wary of the interplay between the quarterly statement performance requirements and the SEC’s Marketing Rule. For example, if a quarterly statement is posted to a data room or otherwise distributed to prospective investors in a manner that causes it to become an “advertisement,” the performance required to satisfy the Private Fund Adviser Rules for an illiquid fund would not be sufficient to meet Marketing Rule requirements. In addition, the presentation of fund-level performance reflecting the application of actual fund fees may be inconsistent with the SEC’s position in the Marketing Rule Adopting Release when used in an advertisement.³

Private Fund Audits. The Final Rules require Private Fund RIAs to undergo a financial statement audit and deliver audited financial statements to private fund investors consistent with the audit exception in Rule 206(4)-2 under the Advisers Act (the Custody Rule).

Adviser-Led Secondaries. The Final Rules prohibit adviser-led secondary transactions by a Private Fund RIA unless, prior to the date that the fund investors are required to respond to a written request by the adviser or related person to participate in the transaction, the Private Fund RIA distributes to investors (i) an opinion obtained from an independent opinion provider that the price being offered is fair or stating the value, or range of values, of the assets to be sold in connection with the transaction; and (ii) a summary of any material business relationships the Private Fund RIA (or its related persons) has with the independent opinion provider.

Private Fund Adviser Rules Applicable to all Private Fund Advisers:

Restricted Activities. Under the Final Rules, Private Fund Advisers are restricted from engaging in the following practices:

• Charging or allocating to a private fund expenses associated with an investigation of the Private Fund Adviser (or its related persons) by regulatory authorities, absent written consent by fund investors. However, regardless of any consent, a Private Fund Adviser may not charge or allocate fees and expenses stemming from an investigation that results or has resulted in sanctions for violations of the Advisers Act or the rules thereunder.
• Charging or allocating to a private fund any regulatory, compliance, or examination expenses of the Private Fund Adviser (or its related persons) by regulatory authorities, unless such expenses are disclosed in a written notice to investors within 45 days of the end of the fiscal quarter in which the expenses were incurred.
• Reducing the amount of an adviser’s (or a related person’s) clawback by actual, potential or hypothetical taxes, unless the Private Fund Adviser discloses in a written notice the aggregate dollar amounts of the adviser clawback, both before and after any such reduction, within 45 days of the end of the fiscal quarter in which the clawback occurs.
• Charging or allocating fees and expenses related to a private fund portfolio investment held by multiple funds on a non-pro rata basis, unless the charge or allocation is fair and equitable under the circumstances and the Private Fund Adviser first distributes a written notice describing the allocation and how it is fair and equitable under the circumstances.
• Borrowing money, securities or other private fund assets, or receiving a loan or extension of credit from a private fund, unless the Private Fund Adviser distributes a written description of the material terms of the proposed borrowing to the fund’s investors and obtains written investor consent. The SEC notes in the Adopting Release that this prohibition will not prohibit a Private Fund Adviser from borrowing directly from individual investors outside of the fund.

Although the Final Rules do not include the proposed prohibition on charging a portfolio company for services the manager does not provide (e.g., monitoring, servicing, consulting, etc.), the SEC stated in the Adopting Release that it believes this activity “generally already runs contrary to an adviser’s obligations to its clients under the Federal fiduciary duty.”⁴ Notwithstanding this guidance, Private Fund Advisers may continue to receive payments in advance for services reasonably expected to be provided in the future, provided that prepaid amounts for unperformed services are refunded.

Private funds that commenced operations prior to the compliance date would be grandfathered from, and therefore not required to comply with, the restrictions above that require investor consent (restricting a Private Fund Adviser from borrowing from a private fund and from charging for certain investigation fees and expenses). However, this legacy status does not permit a Private Fund Adviser to charge or allocate fees and expenses related to an investigation that results or has resulted in a sanction for a violation of the Advisers Act or the rules thereunder. In addition, any new borrowing arrangements with an existing fund established after the applicable compliance date must comply with the Final Rules.

Preferential Treatment and Restrictions on Side Letters. The Final Rules prohibit Private Fund Advisers from providing preferential redemption rights or information regarding portfolio holdings or exposures to an investor (or an investor in a similar pool of assets) if the preferential treatment would reasonably be expected to have a material, negative effect on other investors. The rule provides limited exceptions where the redemption rights are required by law or where the redemption or information rights are offered to all existing and future investors in the private fund (and any similar pool of assets). The SEC provided legacy status to existing funds with respect to these prohibitions for agreements entered into prior to the applicable compliance date. 

All forms of preferential treatment are subject to requirements for written disclosure to investors, including: (i) advance written notice to prospective investors of any preferential material economic terms provided to other investors; (ii) written notice to current investors of any other type of preferential treatment; and (iii) annual notice of any preferential treatment provided in the period since the prior written notice.

Recordkeeping and Compliance Rule Amendments

The SEC also amended Rule 204-2 under the Advisers Act (Recordkeeping Rule) to require Private Fund RIAs to maintain certain documents relating to the Final Rules.

While unrelated to the other Final Rules, the SEC also took the opportunity to update Rule 206(4)-7 (Compliance Rule). Following the compliance date, all registered investment advisers (including those that do not manage private funds) will need to document their annual reviews of their compliance policies and procedures in writing.

Compliance Dates

The Final Rules will be effective 60 days after publication in the Federal Register (Effective Date). The compliance date for the quarterly statement and private fund audit rules will be 18 months after the Effective Date. The compliance date for the adviser-led secondaries, preferential treatment and restricted activities rules will be 12 months after the Effective Date for Private Fund Advisers with $1.5 billion or more in private fund assets and 18 months after the Effective Date for Private Fund Advisers with less than $1.5 billion in private fund assets. The compliance date for the amended Compliance Rule is 60 days after the Effective Date.

Footnotes

1) Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, Release No. IA-6383 (Aug. 23, 2023) (Adopting Release).

2) Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, Release No. IA-5955 (Feb. 9, 2022).

3) Investment Adviser Marketing, Release No. IA-5653 (Dec. 22, 2021), at n.590 (“If the fee to be charged to the intended audience is anticipated to be higher than the actual fees charged, the adviser must use a model fee that reflects the anticipated fee to be charged in order not to violate the [Marketing Rule’s] general prohibitions.”).

4) Adopting Release at 26.