Just over a month ago, the Securities and Exchange Commission (SEC) adopted new rules for venture capital (VC) and other private fund advisers under the Investment Advisers Act of 1940 (Advisers Act). These new rules, which had been highly anticipated since they were proposed in February of last year, will be effective November 13, 2023, although compliance will not be required for some time (see the transition period discussed below). Among other requirements, the new rules will impose additional disclosure, reporting and consent obligations – all of which will increase costs to advisers, not to mention opening them up to new enforcement actions and deficiency citations by the SEC and its staff.
The new rules cover the following topics:
- Preferential treatment granted to select investors
- Restricted activities of private fund advisers
- Quarterly reporting of fees and expenses, adviser compensation and performance metrics
- Private fund audits
- Valuation or fairness opinions for adviser-led secondary transactions
Rules related to the first two topics will apply to both registered investment advisers (RIAs) and exempt reporting advisers (ERAs), while rules related to the last three topics will apply only to RIAs. The SEC also adopted an amendment to an existing rule that will require RIAs to document their annual compliance reviews.
This post is intended to provide a summary of the new rules that would be most pertinent to VC advisers.
A note to our clients based outside the United States: The new rules will not apply to a non-US adviser with respect to its non-US funds, even if there are US investors in those funds. For this purpose, the SEC considers a non-US adviser to be an adviser whose principal office and place of business is outside of the US. The new rules will apply to a non-US adviser with respect to its US funds.
Rules applicable to all private fund advisers (RIAs and ERAs)
1) Rule 211(h)(2)-3 – Preferential Treatment Rule
The Preferential Treatment Rule will limit advisers from directly or indirectly providing preferential treatment – whether by agreement via a side letter or otherwise – to select investors in a fund, and in certain circumstances, investors in a similar pool of assets, unless the adviser discloses such preferential treatment to all investors, and in certain circumstances, offers the same treatment to all investors. A “similar pool of assets” would be a pooled investment vehicle with substantially similar investment policies, objectives or strategies to those of the fund and would generally pick up parallel funds, feeder funds and co-investment funds. The term will likely capture vehicles outside of what VC firms would typically view as a “substantially similar pool of assets.” For example, the SEC has stated that an adviser’s healthcare-focused fund may be considered a “similar pool of assets” to the adviser’s technology-focused fund.
The Preferential Treatment Rule will prohibit an adviser from granting an investor in a private fund, or a 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 fund or in a similar pool of assets. There is an exception if an investor is required to redeem due to applicable laws (US or non-US), or if the adviser has offered the same redemption ability to all other existing investors (e.g., offered different share classes to all investors (but the share class must not be contingent on investment size)) and will continue to offer such redemption ability to all future investors in the same private fund and any similar pool of assets.
This aspect of the Preferential Treatment Rule is likely not going to have a large impact on VC funds, given that redemptions are impractical – if not impossible – for such funds, and are not permitted by the Advisers Act definition of “venture capital fund,” except in extraordinary circumstances. That being said, the rule will apply to ad hoc redemptions, and the SEC has indicated that extraordinary circumstances may be exactly the circumstances where preferential redemption rights for certain investors are most likely to have a material, negative effect on other investors. So, to the extent that a VC firm permits a one-off redemption to an investor that is not required by applicable laws, it will need to reasonably determine – and we would recommend documenting – that the redemption would not have a material, negative effect on other investors.
The Preferential Treatment Rule will prohibit an adviser from providing information (whether through formal or informal communication, or through written, visual or oral means) regarding portfolio holdings or exposures of the private fund, or of a similar pool of assets, to any investor in the fund if the adviser reasonably expects that providing the information would have a material, negative effect on other investors in that fund or in a similar pool of assets. There is an exception to this prohibition if the adviser offers such information to all existing investors in the private fund and any similar pool of assets at the same time or substantially the same time.
Helpfully, the SEC stated in adopting the rule that it generally would not view preferential information rights provided to an investor in an illiquid fund, such as a VC fund, as having a material, negative effect on other investors. However, the SEC did not provide a blanket exception for illiquid funds, stating instead that a facts and circumstances analysis would be required. The SEC has said that advisers would not be expected to predict how investors will react to information; rather, they would need to form only a reasonable expectation based on the facts and circumstances. VC advisers might consider whether information provided to certain investors – including in connection with their representation on limited partner advisory committees (LPACs) – should be subject to contractual provisions around non-use, in addition to nondisclosure and confidentiality.
Disclosure of preferential treatment
The Preferential Treatment Rule also will require written notice of all preferential treatment to both prospective and current investors in the fund. Disclosure will need to be provided to prospective investors – prior to their admission – if the preferential treatment is related to any material economic terms (e.g., the cost of investing, liquidity rights, fee breaks and co-investment rights). Other preferential treatments (i.e., those that are not related to any material economic terms) will need to be provided to current investors in the fund as soon as reasonably practicable following the end of the fund’s fundraising period (or, in the case of a liquid fund, following the investor’s investment in the fund). While “as soon as reasonably practicable” will depend on the facts and circumstances, the SEC has said that distributing the notice within four weeks would generally be appropriate. To the extent that an adviser provides additional preferential treatment to investors after the fund closes, it will need to provide written notice of such additional treatment on an annual basis.
Disclosure of preferential terms will require specificity. For example, if an adviser provides an investor with lower fee terms in exchange for a significantly higher capital commitment than others, the adviser will need to describe the lower fee terms, including the applicable rate (or range of rates if multiple investors pay such lower fees), in order to provide sufficiently specific information as required by the rule. Providing copies of side letters with identifying information redacted (if applicable) would comply with the disclosure requirements, as would a sufficiently specific written summary of preferential terms, such as a compendium or master side letter covering all preferential terms, similar to the practice used for most favored nation (MFN) elections.
2) Rule 211(h)(2)-1 – Restricted Activities Rule
The Restricted Activities Rule will prohibit private fund advisers from engaging in the following activities, subject to either disclosure to, and/or consent from, investors. Each consent-based exception will require an adviser to seek consent from all investors in the private fund and obtain consent from at least a majority in interest of investors that are not related persons of the adviser (i.e., LPAC consent will not suffice). A fund’s governing documents may generally prescribe the manner and process by which the applicable consent is obtained.
Regulatory, compliance and examination expenses (post-disclosure)
The Restricted Activities Rule will prohibit an adviser from charging private fund clients:
- Regulatory or compliance fees and expenses of the adviser or its related persons
- Fees and expenses associated with an examination of the adviser or its related persons by any governmental or regulatory authority
unless the adviser distributes written notice of any such fees or expenses, including the dollar amounts, to investors in the fund within 45 days after the end of the fiscal quarter in which the charge occurs.
The written notice should include a detailed accounting of each category of such fees and expenses, and each specific category should be listed as a separate line item rather than grouped into broad categories such as “compliance expenses.”
Investigation expenses (consent)
The Restricted Activities Rule will prohibit an adviser from charging private fund clients fees and expenses associated with an investigation of the adviser or its related persons by any governmental or regulatory authority, unless the adviser seeks written consent from all investors and obtains written consent from at least a majority in interest of the investors. However, in no event will an adviser be able to charge fees or expenses related to an investigation that results – or has resulted in – a court or governmental authority imposing a sanction for a violation of the Advisers Act or Advisers Act rules. If an adviser is ultimately sanctioned, and the adviser has already charged the fund for investigation expenses (i.e., with consent from the investors), the adviser will be required to refund the fund for the fees and expenses associated with the investigation. In light of circumstances in which governmental or regulatory bodies may not formally notify an adviser that it is under investigation, whether the adviser is under investigation would be determined based on available information. To request consent, advisers will generally need to list each category of fee or expense as a separate line item, rather than grouping them into broad categories, and describe how each such fee or expense is related to the relevant investigation.
Adviser clawbacks – reduced for taxes (post-disclosure)
The Restricted Activities Rule will prohibit an adviser from reducing the amount of any adviser clawback by actual, potential or hypothetical taxes applicable to the adviser or its related persons (or their respective owners or interest holders), unless it distributes written notice to the investors setting forth the aggregate dollar amounts of the clawback, both before and after such reduction for taxes, within 45 days after the end of the fiscal quarter in which the adviser clawback occurs.
Non-pro rata fees and expenses (pre-disclosure)
The Restricted Activities Rule will prohibit an adviser from charging or allocating fees and expenses related to a portfolio investment (whether or not consummated) on a non-pro rata basis when multiple clients are investing in the same portfolio investment, unless:
- The non-pro rata charge or allocation is fair and equitable under the circumstances.
- Prior to charging or allocating such fees or expenses to a fund, the adviser distributes to each investor in the fund a written notice of the non-pro rata charge or allocation and a description of how it is fair and equitable under the circumstances.
Non-pro rata allocation may be fair and equitable where, for example, an expense is related to a bespoke structuring for one fund participating in an investment, or where one fund receives a greater benefit from an expense relative to other funds participating in the investment. Stating that there may be multiple methods to determine pro rata allocations, the SEC did not define pro rata.
The Restricted Activities Rule will prohibit an adviser from borrowing from a private fund client, unless the adviser distributes a written description of the material terms of the borrowing (e.g., amount to be borrowed, interest rate and repayment schedule) to the investors in the fund, seeks their consent for the borrowing and obtains written consent from at least a majority in interest of the investors that are not related persons of the adviser. The restriction will not apply to borrowings from a third party on the fund’s behalf or the adviser’s borrowings from individual investors outside of the fund, such as a bank that is invested in the fund.
Helpfully, the SEC has stated that it would not interpret management fee offsets and ordinary course tax advances (i.e., arrangements structured to contemplate amounts that reduce an adviser’s future income, as opposed to amounts that will be repaid to the fund) as borrowings subject to the rule. VC firms will need to determine whether other arrangements permitted under fund documents would be considered a borrowing subject to the rule.
Rules applicable to RIAs only (not applicable to ERAs)
3) Rule 211(h)(1)-2 – Quarterly Statements Rule
The Quarterly Statements Rule will require RIAs to private funds to distribute quarterly statements to investors, reporting detailed information regarding:
- Compensation and other amounts allocated or paid by the fund and portfolio investments to the adviser and its related persons.
- Other fees and expenses paid by the fund to third parties.
- Portfolio performance.
Statements will need to be delivered within 45 days after the end of each of the first three fiscal quarters of each fiscal year, and 90 days after the end of each fiscal year. A fund of funds, which the SEC describes as a fund that invests substantially all of its assets in the equity of third-party funds, will have 75 days after the end of each of the first three fiscal quarters, and 120 days after the end of each fiscal year. The first statement of a newly formed fund will be due following the second full fiscal quarter of operating results.
The rule requires advisers to determine – with substantiation – that a fund is either a liquid fund or an illiquid fund no later than when the adviser sends the initial quarterly statement. While most VC funds will be illiquid funds, certain hybrid funds may be liquid funds, and a fund may switch from being a liquid fund to an illiquid fund, or vice versa. Determination of whether a fund is a liquid fund or an illiquid fund turns on whether the fund is required to redeem interests upon an investor’s request and whether it has limited opportunities, if any, for investors to withdraw before termination of the fund. A fund that provides semiannual redemption rights would generally be a liquid fund. The rule requires different performance metrics depending on whether a fund is a liquid fund or an illiquid fund.
Quarterly statements will need to include, in table format, 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, e.g., management fees, sub-advisory fees or carried interest (adviser compensation).
- All other fees and expenses allocated to or paid by the fund during the reporting period (fund expenses).
- The amounts of any offsets or rebates carried forward during the reporting period to the subsequent quarterly period to reduce future payments or allocations to the adviser.
The adviser compensation and fund expenses will need to be presented both before and after application of any offsets, rebates or waivers. There is no exclusion for de minimis expenses, smaller expenses may not be grouped into broad categories, and no expense may be labelled as miscellaneous.
Portfolio investment table
Quarterly statements will need to include, in table format, a detailed accounting of all portfolio investment compensation allocated or paid by each covered portfolio investment during the reporting period. Portfolio investment is defined as any entity or issuer in which the private fund has invested directly or indirectly, and would capture holding companies, subsidiaries, special purpose vehicles (SPVs) and master funds, as well as underlying third-party funds. Portfolio investment compensation is defined as any compensation, fees and other amounts (e.g., origination, management, consulting, monitoring, servicing, transaction, administrative, advisory, closing, disposition, directors, trustees or similar fees or payments) allocated or paid to the adviser or any of its related persons by a portfolio investment, which is attributable to a fund’s interest in such portfolio investment. Portfolio investment compensation is not limited to circumstances in which an adviser has discretion or authority over the portfolio investment.
Quarterly statements will need to include standardized performance information. For illiquid funds, performance will need to be shown based on internal rates of return and multiples of invested capital (both gross and net) for the entire portfolio, as well as internal rates of return and multiples of invested capital (gross only) for the realized and unrealized portions of the portfolio, with the realized and unrealized performance shown separately. For partially realized investments, advisers will need to determine whether to include them in the realized or the unrealized portion. Performance figures will need to cover the period from inception of the fund through the end of the quarter covered by the quarterly statement (or, to the extent quarter-end numbers are not available at the time the adviser distributes the quarterly statement, through the most practicable date), and will need to be disclosed with and without the impact of fund-level subscription facilities. There is no exception for short-term subscription facilities. As noted above, most VC funds will be illiquid funds; but firms should keep in mind that a fund meeting the definition of a liquid fund will need to disclose a different set of metrics, based on net total returns.
In calculating performance, advisers will generally be expected to exclude the adviser’s (and any affiliates’) interests. Advisers also will need to include a statement of contributions and distributions showing all capital inflows the fund received from investors and all capital outflows distributed to investors, with the value and date of each inflow and outflow, along with the net asset value of the fund as of the end of the reporting period.
In addition to the above, quarterly statements will need to include prominent disclosure (no hyperlinks and no separate documents) regarding the manner in which all expenses, payments, allocations, rebates, waivers and offsets are calculated, as well as cross-references to the relevant sections of the fund’s organizational and offering documents that set forth the applicable calculation methodology. Additionally, quarterly statements will need to include the date as of which the performance information is current through, and prominent disclosure (no hyperlinks and no separate documents) of the criteria used and assumptions made in calculating the performance. Advisers will need to consolidate reporting for similar pools of assets to the extent doing so would provide more meaningful information to the fund’s investors and would not be misleading. Advisers also will need to use clear, concise, plain English and present information in a format that facilitates review from one quarterly statement to the next.
4) Rule 206(4)-10 – Audit Rule
The Audit Rule will require RIAs to cause each private fund they advise (directly or indirectly, including in a sub-advisory capacity) to undergo a financial statement audit that meets the requirements set forth in Advisers Act Rule 206(4)-2 (Custody Rule), and to cause the audited financial statements to be delivered in accordance with the Custody Rule. Most RIAs already rely on private fund audits to comply with the Custody Rule. However, unlike the Custody Rule, there is not an option of surprise examination to comply with the Audit Rule, and the Audit Rule will apply regardless of whether an adviser has “custody” within the meaning of the Custody Rule. In the case of a fund that an adviser does not control (e.g., a sub-advised fund), the Audit Rule will require the adviser to take all reasonable steps to cause the fund to undergo an audit and have its financial statements delivered.
5) Rule 211(h)(2)-2 – Adviser-Led Secondaries Rule
The Adviser-Led Secondaries Rule will require RIAs conducting an adviser-led secondary transaction to:
- Obtain and distribute a fairness opinion or a valuation opinion from an independent opinion provider.
- Prepare and distribute a written summary of any material business relationships the adviser or its related persons have – or have had within the two-year period immediately prior to the issuance of the opinion – with the independent opinion provider.
An adviser-led secondary transaction would be a transaction initiated by the adviser or any of its related persons that offers private fund investors the choice between:
- Selling all or a portion of their interests in the private fund.
- Converting or exchanging them for new interests in another vehicle advised by the adviser or its related persons.
The SEC would not consider the rule to apply to cross trades where the adviser does not offer the investors the choice to sell, convert or exchange their fund interests, and rebalancing between parallel funds generally will not be captured by the adviser-led secondary transaction definition. Distribution of the opinion and the written summary will need to occur prior to the due date of the election form.
Other rules applicable to RIAs only (not applicable to ERAs)
6) Rule 206(4)-7 – Compliance Rule
The SEC amended the existing Compliance Rule, which applies to all RIAs (i.e., not just RIAs to private funds), to require RIAs to start documenting their annual compliance reviews in writing. While documentation has always been a best practice, it is not currently required by the Compliance Rule.
7) Rule 204-2 – Recordkeeping Rule
The SEC also amended the existing Recordkeeping Rule to require RIAs to retain records related to the new rules, including notices, consents, quarterly statements, audited financials, certain determinations, and fairness or valuation opinions.
Compliance dates and transition periods
The rules will become effective on November 13, 2023.
Except with respect to the Compliance Rule, however, advisers will have a transition period to come into compliance.
- Advisers with less than $1.5 billion in private fund assets will need to comply with all applicable rules by March 14, 2025.
- Advisers with $1.5 billion or more in private fund assets will need to comply with the Restricted Activities Rule, Preferential Treatment Rule and Adviser-Led Secondaries Rule by September 14, 2024, and the Quarterly Statement Rule and Audit Rule by March 14, 2025.
- RIAs must begin documenting their annual compliance reviews starting on November 13, 2023.
Limited grandfathering/legacy status
The Preferential Treatment Rule and the Restricted Activities Rule both contain limited grandfathering provisions that confer legacy status to certain contractual agreements governing private funds that have commenced operations as of the applicable compliance date. Importantly, the adviser must have engaged in bona fide activity directed toward operating the fund as of the compliance date in order for legacy status to apply. The SEC has said this would include issuing capital calls, holding an initial fund closing and conducting due diligence on potential fund investments – or making an investment on behalf of the fund.
Specifically, legacy status may apply to the restrictions on preferential transparency, preferential redemption, charging a private fund fees or expenses associated with an investigation of the adviser or its related persons (unless the investigation results in a sanction for a violation of the Advisers Act), and borrowing from a fund. Legacy status would apply with respect to the foregoing if both of the following are true:
- A contractual agreement was entered into in writing prior to the applicable compliance date.
- The application of the new rules would require the parties to amend such an agreement.
Agreements subject to legacy status include limited partnership agreements, operating agreements, side letters, subscription agreements, promissory notes and credit agreements.
Legacy status will not apply to the written notice requirements under the Preferential Treatment Rule and the Restricted Activities Rule.
These are significant rules, and significant effort will be required to come into compliance with them. While some firms may have heard that there is pending litigation with respect to the new rules, and perhaps have been considering a wait-and-see approach, we encourage fund managers to start focusing on these rules sooner rather than later. An outcome on the pending litigation is not expected in the short term, and the September 14, 2024, compliance date for larger firms is less than a year away.
- If not already in progress, we encourage fund managers to become familiar with the new rules now to begin assessing which of the new requirements and restrictions will apply to them.
- Upon attaining a working grasp of the new rules, firms should review various documents and practices – such as fund governing documents, side letters, informal arrangements with investors, practices and methodologies that can be considered borrowings from a fund, bookkeeping and expense tracking procedures, and arrangements with underlying funds and portfolio investments.
- Firms also should speak with auditors, administrators, intermediaries and service providers and work on preparing mock notices, statements and consents.
- A medium-term project will be crafting policies and procedures to comply with the new requirements. Firms that work with compliance consultants will likely receive outreach regarding this step.
- Long term, firms should adopt and implement their updated policies and procedures, train employees and stakeholders, and continue to monitor and adjust their practices, paying attention to industry standards that develop and any guidance the SEC staff may provide.