On February 9, 2022, the Securities and Exchange Commission (SEC) proposed far-reaching new rules and rule amendments under the Investment Advisers Act of 1940, as amended (Advisers Act). The rules and amendments would substantively regulate several aspects of an investment adviser’s relationship with a private fund and its investors that have historically been left to the marketplace and to the negotiating process between a private fund adviser and its investors. While some of the proposals would affect only registered investment advisers, other proposals would affect exempt reporting advisers, state-registered investment advisers and unregistered foreign investment advisers. And while most of the proposals would affect only advisers that advise private funds – funds that are excepted from the definition of “investment company” by virtue of the exceptions set forth in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 (1940 Act) – the SEC’s proposal to require SEC-registered advisers to document the annual review of their compliance policies and procedures in writing would apply to any registered investment adviser, regardless of whether it advises a private fund. The chart below summarizes the proposed new rules and amendments, and identifies the scope of advisers that would be affected.

Discussion

1. Quarterly statements

Proposed new Advisers Act Rule 211(h)(1)-2 (Quarterly Statement Rule) would require any investment adviser to one or more private funds that is registered or required to be registered with the SEC (each, a registered private fund adviser) to prepare a quarterly statement that includes certain information regarding fees, expenses and performance for any private fund that it advises and distribute the quarterly statement to the private fund’s investors within 45 days after each calendar quarter end, unless a quarterly statement that complies with the Quarterly Statement Rule is prepared and distributed by another person.

a. Fee and expense disclosure

The SEC believes that existing provisions in private fund organizational documents do not provide investors with enough information about:

• what fees and expenses will be charged;
• how much those fees and expenses will be; and
• how often fees and expenses will be charged.

The SEC would require registered private fund advisers to present information in quarterly statements in a standardized format. In particular, a registered private fund adviser would be required to disclose:

• 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 during the reporting period (adviser compensation);
• a detailed accounting of all fees and expenses paid by the private fund during the reporting period other than adviser compensation, including, but not limited to, organizational, accounting, legal, administration, audit, tax, due diligence and travel expenses (collectively, 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.

To the extent that a fund expense also could be characterized as adviser compensation under the Quarterly Statement Rule, the Quarterly Statement Rule would require a registered private fund adviser to disclose the payment or allocation as adviser compensation and not as a fund expense in the quarterly statement.

A registered private fund adviser would be required to disclose compensation, fees and other amounts allocated or paid to its “related persons” as well as to itself. The SEC would define “related persons” to include:

• all officers, partners or directors (or any person performing similar functions) of the adviser;
• all persons directly or indirectly controlling or controlled by the adviser;
• all current employees (other than employees performing only clerical, administrative, support or similar functions) of the adviser; and
• any person under common control with the adviser.

“Person” is defined under the federal securities laws to include entities as well as humans. Therefore, references to persons would also encompass corporations, limited liability companies, partnerships and other business structures.

In addition to adviser compensation, fund expenses and rebates, registered private fund advisers would be required to disclose the following information about any portfolio investment that allocated or paid the adviser or its related persons portfolio investment compensation during the reporting period (so-called portfolio investment compensation):

• a detailed accounting of all portfolio investment compensation allocated or paid by each covered portfolio investment during the reporting period;
• the private fund’s ownership percentage of each such covered portfolio investment as of the end of the reporting period; if the fund does not have an ownership interest in the covered portfolio investment, the adviser would be required to list zero percent as the fund’s ownership percentage along with a brief description of the fund’s investment in such covered portfolio investment.

The Quarterly Statement Rule would define “portfolio investment” as any entity or issuer in which the private fund has invested directly or indirectly. This would encompass investments through holding companies, subsidiaries, acquisition vehicles, special purpose vehicles and other vehicles. It would also encompass nontraditional investments, such as music royalties, aircraft and tanker vessels. However, the SEC would not treat an investment in a derivative as an investment in the derivative’s counterparty.

Under the Quarterly Statement Rule, a registered private fund adviser would be required to disclose information regarding only covered portfolio investments, which the SEC would define as portfolio investments that allocated or paid the investment adviser or its related persons portfolio investment compensation during the reporting period. If the adviser does not receive such compensation from a particular portfolio investment, the Quarterly Statement Rule would not require it to list any information regarding that portfolio investment for the applicable reporting period. An adviser would be required to disclose the fund’s ownership percentage of each covered portfolio investment that paid or allocated portfolio-investment compensation to the adviser or its related persons during the reporting period, as of the end of the reporting period.

The Quarterly Statement Rule would also require each statement to include prominent disclosure regarding how the adviser calculates expenses, payments, allocations, rebates, waivers and offsets. The quarterly statement would also be required to include cross-references to the relevant sections of the private fund’s organizational and offering documents that set forth the calculation methodology.

b. Performance disclosure

The Quarterly Statement Rule would establish performance reporting requirements for private funds, which would differ depending on whether a private fund is a liquid fund or an illiquid fund. The SEC proposes to define an illiquid fund as a private fund that:

• has a limited life;
• does not continuously raise capital;
• is not required to redeem interests upon an investor’s request;
• has as a predominant operating strategy the return of the proceeds to investors from disposition of investments;
• has limited opportunities, if any, for investors to withdraw before termination of the fund; and
• does not routinely acquire (directly or indirectly) as part of its investment strategy market-traded securities and derivative instruments.

A liquid fund would be defined as any private fund that is not an illiquid fund. The SEC states that liquid funds generally allow periodic investor redemptions (whether monthly, quarterly or semiannually) and primarily invest in market-traded securities and therefore determine their net asset value regularly.

The Quarterly Statement Rule would require an adviser to a liquid fund to show performance based on net total return on an annual basis since the fund’s inception, over prescribed time periods and on a quarterly basis for the current year. Specifically, an adviser to a liquid fund would be required to disclose the liquid fund’s:

• annual net total returns for each calendar year since inception;
• average annual net total returns over the one, five and ten calendar year periods (if available); and
• cumulative net total return for the current calendar year as of the end of the most recent calendar quarter covered by the quarterly statement.

For illiquid funds, the Quarterly Statement Rule would require an adviser to show performance based on the internal rate of return and a multiple of invested capital, on both a net and a gross basis.¹ Specifically, advisers to illiquid funds would be required to disclose the following performance measures in the quarterly statement, shown since inception of the illiquid fund through the end of the quarter covered by the quarterly statement,² and computed without the impact of any fund-level subscription facilities:

• gross internal rate of return³ and gross multiple of invested capital⁴ for the illiquid fund;
• net internal rate of return and net multiple of invested capital for the illiquid fund; and
• gross internal rate of return and gross multiple of invested capital for the realized and unrealized portions of the illiquid fund’s portfolio, with the realized and unrealized performance shown separately.

The Quarterly Statement Rule also would require advisers to provide investors with a statement of contributions and distributions for the illiquid fund.⁵ The Quarterly Statement Rule would require an adviser to display the different categories of required performance information with equal prominence.

The Quarterly Statement Rule would require registered private fund advisers to include prominent disclosure of the criteria used and assumptions made in calculating private fund performance. The Quarterly Statement Rule would require the disclosure to be within the quarterly statement. An adviser would not be allowed to provide the information solely in a separate document, website hyperlink or QR code, or other separate disclosure.

The Quarterly Statement Rule would permit registered private fund advisers to include other performance metrics in the quarterly statement as long as the quarterly statement presents the performance metrics prescribed by the Quarterly Statement Rule and complies with the other requirements in the Quarterly Statement Rule. However, the SEC specifically cautions that advisers that choose to do so may need to consider whether such information would be subject to the marketing rule (Advisers Act Rule 206-4(1)).

c.Preparation and distribution of quarterly statements

The Quarterly Statement Rule would require quarterly statements to be prepared and distributed to fund investors within 45 days after each calendar quarter end. For a newly formed private fund, the Quarterly Statement Rule would require registered private fund advisers to prepare and distribute a quarterly statement after the private fund has two full calendar quarters of operating results and continuously each calendar quarter thereafter. An adviser would be required to provide information for any stub periods that precede its first two full calendar quarters of operating results (that is, from the date of the fund’s inception to the beginning of the first calendar quarter during which the fund begins to produce operating results).

The SEC noted that, unlike Rule 206(4)-2 under the Advisers Act (Custody Rule), the Quarterly Statement Rule does not explicitly permit a private fund investor to designate an independent representative to receive quarterly statements on its behalf. The SEC specifically solicits comment on whether it should adopt a similar provision in the Quarterly Statement Rule.

d. Consolidated reporting for certain fund structures

The Quarterly Statement Rule would require registered private fund advisers to consolidate reporting for substantially similar pools of assets to the extent doing so would provide more meaningful information to the private fund’s investors and would not be misleading. The SEC noted that this would require an adviser to a private fund that utilized a master-feeder structure to provide feeder fund investors with a single quarterly statement covering the applicable feeder fund and the feeder fund’s proportionate interest in the master fund on a consolidated basis, so long as the consolidated statement would provide more meaningful information to investors and would not be misleading.

The SEC noted that certain private funds have multiple classes (or other groupings such as series or tranches) of interests or shares. The Quarterly Statement Rule would require the quarterly statement to present fund-wide information. The SEC solicits comments on several aspects of the potential impact of the Quarterly Statement Rule on private funds with multiple classes, series or tranches, including:

• whether the SEC should require disclosure of class-specific fees and expenses, or of the differences among classes; and
• whether the SEC should require quarterly statements for multi-class (or multi-series or multi-tranche) private funds to present class-by-class (or series-by-series or tranche-by-tranche) information to the extent each class (or series or tranche) holds different investments.

e. Format and presentation standards

The Quarterly Statement Rule would require a registered private fund adviser to use clear, concise, plain English in its quarterly statement. Any information that an adviser chooses to include in a quarterly statement but that is not required to be included in the quarterly statement would be required to be as short as practicable, not more prominent than the required information, and not obscure or impede an investor’s understanding of the mandatory information. In addition, the Quarterly Statement Rule would require an adviser to present information in the quarterly statement in a format that facilitates review from one quarterly statement to the next.

The proposed format and content requirements would apply to each element of a quarterly statement, including the proposed requirements to disclose the manner in which expenses, payments, allocations, rebates, waivers and offsets are calculated and to cross-reference sections of the private fund’s organizational and offering documents.

f. Recordkeeping associated with quarterly statements

The SEC is proposing companion amendments to Advisers Act Rule 204-2 (Books and Records Rule) to require advisers to retain books and records related to the proposed Quarterly Statement Rule. These proposed amendments would require registered private fund advisers to:

• retain a copy of any quarterly statement distributed to fund investors, as well as a record of each addressee, the date(s) the statement was sent, address(es) and delivery method(s);
• retain all records evidencing the calculation method for all expenses, payments, allocations, rebates, offsets, waivers and performance listed on any quarterly statement delivered; and
• make and keep books and records substantiating the adviser’s determination that the private fund it manages is a liquid fund or an illiquid fund.

2. Mandatory private fund adviser audits

Proposed new Advisers Act Rule 206(4)-10 (Audit Rule) would require registered private fund advisers to obtain an annual audit of the financial statements of the private funds they manage. If an adviser does not control the private fund and is neither controlled by nor under common control with the fund, the Audit Rule would instead require the adviser to take all reasonable steps to cause its private fund client to undergo an audit that would satisfy the Audit Rule. The SEC stated that the Audit Rule is based on the Custody Rule and contains many similar or identical requirements, although compliance with either rule would not necessarily satisfy the requirements of the other.

a. Requirements for accountants performing private fund audits

The Audit Rule would require an accountant performing a private fund audit to meet the SEC’s standards of independence. It would also require the independent public accountant performing the audit to be registered with, and subject to regular inspection as of the commencement of the professional engagement period and as of each calendar year-end by, the Public Company Accounting Oversight Board (PCAOB) in accordance with its rules.

b. Auditing standards for financial statements

The Audit Rule would generally require financial statement audits performed for purposes of the Audit Rule to be performed in accordance with the generally accepted auditing standards of the United States (US GAAS).

c. Preparation of audited financial statements

The Audit Rule would generally require audited financial statements to be prepared in accordance with US Generally Accepted Accounting Principles (US GAAP). In the case of financial statements of private funds organized under non-US law or that have a general partner or other manager with a principal place of business outside the United States (foreign private funds), the financial statements must contain information substantially similar to statements prepared in accordance with US GAAP, and material differences with US GAAP must be reconciled.

d. Prompt distribution of audited financial statements

The Audit Rule would require audited financial statements to be distributed to current investors “promptly” after the completion of the audit rather than pursuant to a specific deadline (for example, 120 days). According to the SEC, this provision is intended to provide some flexibility without affecting investor protection.

e. Notification to SEC of modified opinion, termination or resignation

The SEC noted that unlike the Custody Rule, the Audit Rule would require there to be a written agreement between the adviser or the private fund and the auditor pursuant to which the auditor would be required to notify the SEC’s Division of Examinations upon the auditor’s termination or issuance of a modified opinion. In particular, the auditor would need to notify the SEC:

• promptly upon issuing an audit report to the private fund that contains a modified opinion; and
• within four business days of resignation or dismissal from, or other termination of, the engagement, or upon removing itself or being removed from consideration for being reappointed.

The accountant making such a notification would be required to provide its contact information and indicate its reason for sending the notification.

f. Companion amendments to books and records rule

The SEC is proposing companion amendments to the Books and Records Rule that would require an adviser to keep a copy of any audited financial statements, along with a record of each addressee and the corresponding date(s) the statements were sent, address(es), and delivery method(s) for each such addressee. An adviser to a private fund with which it is not in a control relationship would also be required to keep a record documenting steps that it took to cause the private fund client to undergo a financial statement audit that would comply with the Audit Rule.

3. Adviser-led secondaries

Proposed new Advisers Act Rule 211(h)(2)-2 (Adviser-Led Secondaries Rule) would require a registered private fund adviser to obtain a fairness opinion in connection with certain adviser-led secondary transactions where an adviser offers private fund investors the option to sell their interests in the private fund, or to exchange them for new interests in another vehicle advised by the adviser. The Adviser-Led Secondaries Rule would define an adviser-led secondary as a transaction initiated by the adviser or any of its related persons that offers the private fund’s investors the choice to:

• sell all or a portion of their interests in the private fund; or
• convert or exchange all or a portion of their interests in the private fund for interests in another vehicle advised by the adviser or any of its related persons.

According to the SEC, an adviser would generally be viewed as initiating a transaction if it commences a process, or causes one or more other persons to commence a process, that is designed to offer private fund investors the option to obtain liquidity for their private fund interests. An adviser would not generally be viewed as initiating a transaction if the adviser, at the unsolicited request of the investor, assists in the secondary sale of such investor’s fund interest.

The Adviser-Led Secondaries Rule would require an adviser, prior to the closing of an adviser-led secondary transaction, to obtain 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. The opinion could be issued only by an “independent opinion provider,” namely, a provider that (i) provides fairness opinions in the ordinary course of its business and (ii) is not a related person of the adviser. In addition, the Adviser-Led Secondaries Rule would require the adviser to prepare and distribute to private fund investors a summary of any material business relationships the adviser or any of its related persons has, or has had within the past two years, with the independent opinion provider.

The SEC is proposing companion amendments to the Books and Records Rule. The proposed amendments would require advisers to retain a copy of the fairness opinion and material business relationship summary distributed to investors, as well as a record of each addressee, the date(s) the opinion was sent, address(es) and delivery method(s).

4. Prohibited activities

Proposed new Advisers Act Rule 211(h)(2)-1 (Prohibited Activities Rule) would prohibit an investment adviser to a private fund, directly or indirectly, from engaging in certain activities with respect to the private fund or any investor in that private fund, including:

• charging certain fees and expenses to a private fund or portfolio investment, including:
  • 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 (so-called accelerated monitoring fees);
  • fees or expenses associated with an examination or investigation of the adviser or its related persons by governmental or regulatory authorities;
  • regulatory or compliance expenses or fees of the adviser or its related persons; or
  • fees and expenses related to a portfolio investment on a non-pro rata basis⁶ 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;
• reducing the amount of 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 (so-called adviser clawback) by the amount of actual, potential or hypothetical taxes applicable to the adviser, its related persons, or their respective owners or interest holders;
• seeking reimbursement, indemnification, exculpation or limitation of its liability by the private fund or its investors for a breach of fiduciary duty (even if state law or other applicable law would permit the adviser to waive its fiduciary duty), willful misfeasance, bad faith, negligence or recklessness in providing services to the private fund; and
• borrowing money, securities or other fund assets, or receiving an extension of credit from a private fund client.

The Prohibited Activities Rule would apply to all advisers to private funds, regardless of whether they are registered with the SEC or one or more states, exempt reporting advisers, or prohibited from registration. Moreover, the Prohibited Activities Rule would apply even in instances where the activity or practice was disclosed to private fund investors.

The SEC stated that the Prohibited Activities Rule would not apply to a registered non-US investment adviser’s private funds organized outside of the United States, regardless of whether the private funds have US investors.

5. Preferential treatment

Proposed new Advisers Act Rule 211(h)(2)-3 (Preferential Treatment Rule) would completely prohibit investment advisers from engaging in certain practices with respect to a private fund that favor certain investors over others, and would require investment advisers to provide meaningful disclosure to other investors of other types of treatment that are provided to only a subset of investors. If adopted, these proposed changes likely would have profound effects on common side letter practices in the private fund industry. Like the Prohibited Activities Rule, the Preferential Treatment Rule would apply to all advisers to private funds, regardless of whether they are registered with the SEC or one or more states, exempt reporting advisers, or prohibited from registration.

a. Prohibited preferential redemptions

The Preferential Treatment Rule would prohibit an adviser and its related persons from granting an investor in the private fund or in a substantially 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 substantially similar pool of assets. “Substantially similar pool of assets,” in turn, would be defined as a pooled investment vehicle (other than an investment company registered under the 1940 Act or a business development company) with investment policies, objectives or strategies substantially similar to those of the private fund managed by the adviser or its related persons.

b. Prohibited preferential transparency

The Preferential Treatment Rule would also prohibit an adviser and its related persons from providing information regarding the portfolio holdings or exposures of the private fund or of a substantially similar pool of assets to any investor 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 substantially similar pool of assets. The SEC notes that selective disclosure of portfolio holdings or exposures can result in profits or avoidance of losses among those who were privy to the information beforehand at the expense of investors who did not benefit from such transparency.

c. Other preferential treatment

The Preferential Treatment Rule also would prohibit other preferential terms unless the adviser provides certain advance written disclosures⁷ to prospective and current investors. These practices could include the right to refrain from participating in a specific investment a private equity fund plans to make, discounted advisory fees and the ability to increase an investment in a closed fund. The Preferential Treatment Rule would require an adviser to describe specifically the preferential treatment.

d. Recordkeeping requirements for preferential treatment

The SEC is proposing companion amendments to the Books and Records Rule. The amendments would require advisers to retain copies of all written notices sent to current and prospective investors in a private fund pursuant to the Preferential Treatment Rule. In addition, advisers would be required to retain copies of a record of each addressee and the corresponding date(s) the notices were sent, address(es), and delivery method(s) for each addressee.

6. Written documentation requirement for all registered investment advisers’ annual reviews of compliance programs

Proposed amendments to Rule 206(4)-7 (Compliance Rule) would require all SEC-registered investment advisers (including those that do not manage any private funds) to document in writing the annual review of their compliance policies and procedures. The SEC states that it has found that some investment advisers do not make and preserve written documentation of the annual review of their compliance policies and procedures. According to the SEC, its examination staff relies on documentation of the annual review to help it understand an adviser’s compliance program, determine whether the adviser is complying with the Compliance Rule and identify potential weaknesses in the compliance program.

The proposed amendments would not enumerate particular elements that advisers must include in the written documentation of their annual review. The SEC stated that the written documentation requirement is intended to be flexible to allow advisers to continue to use the review procedures they have developed and found most effective.

7. Effective and compliance dates

If the rules and amendments are adopted, the SEC proposes that they take effect 60 days after publication in the Federal Register and that the compliance date fall one year after the effective date.

Conclusion

In 2008, the SEC observed:

Investors have the responsibility, based on disclosure they receive, for selecting their own advisers, negotiating their own fee arrangements, and evaluating their advisers’ conflicts. Therefore, it is critical that clients and prospective clients receive sufficient information about the adviser and its personnel to permit them to make an informed decision about whether to engage an adviser, and having engaged the adviser, how to manage that relationship.⁸

The SEC’s proposed rulemaking represents at least a partial rejection of that philosophy. Much of what has been proposed would replace what investors and their representatives negotiate with their investment advisers with a series of prescriptive requirements and prohibitions. Moreover, some of the SEC’s proposed rulemaking could regulate entities that the SEC may not have intended to regulate.

The SEC has given commenters until April 11 or 30 days after publication in the Federal Register,⁹ whichever is later, to comment on this sweeping proposal.

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^{1 Under the Quarterly Statement Rule, an illiquid fund’s gross performance would not reflect the deduction of fees, expenses and performance-based compensation borne by the private fund.}

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