The U.S. Securities and Exchange Commission (the “SEC”) last week adopted highly anticipated new rules and amendments (the “Adopted Rules”) to the Investment Advisers Act of 1940, as amended (the “Advisers Act”), that will significantly impact how investment advisers – registered and unregistered - manage and administer private funds, such as hedge funds, private equity funds, real estate private equity funds, and venture capital funds. The Adopted Rules follow rules and amendments proposed by the SEC on February 9, 2022 (the "Proposed Rules"), which we summarized in our Client Alert SEC Proposes New Rules to Encourage Private Fund Transparency and Address Certain Conflicts of Interest (sullivanlaw.com).

For purposes of the Adopted Rules and this Client Alert, a “private fund” is an issuer that satisfies the conditions of either exclusion from the definition of an “investment company” in Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940, as amended, other than a fund defined in the Adopted Rules as a “securitized asset fund.” A securitized asset fund is defined in the Adopted Rules as a private fund whose primary purpose is to issue asset-based securities and whose investors are primarily debt holders. Securitized asset funds, now excluded from the Adopted Rules, were originally covered under the Proposed Rules.

As with the Proposed Rules, the Adopted Rules may be categorized into three categories: those applicable only to SEC-registered investment advisers to private funds; those applicable to SEC-registered investment advisers to private funds as well as investment advisers who are not SEC-registered (such as exempt reporting advisers and private foreign advisers); and those applicable to all SEC-registered investment advisers, that is, including SEC-registered investment advisers without private fund clients.

Brief Descriptions of the Adopted Rules

Adopted Rules applicable only to SEC-Registered Investment Advisers to Private Funds

• Private Fund Audits Rule: Rule 206(4)-10
  
  The Adopted Rules require a registered investment adviser providing investment advice directly or indirectly to a private fund, to cause that fund to undergo a financial statement audit that meets those requirements of the Advisers Act’s custody rule, Rule 206(4)-2, applicable to pooled investment vehicles subject to annual audit, and to cause audited financial statements to be delivered to private fund investors.
  
  If an investment adviser to a private fund does not control, is not controlled by, and is not under common control with the private fund, such as if the investment adviser is managing the assets of a private fund as a sub-adviser to an unaffiliated investment manager, the investment adviser must take all reasonable steps to cause the private fund client to undergo a financial statement audit that meets the requirements of audited financial statements under the Advisers Act’s custody rule and to deliver those audited financial statements to investors, if they are not otherwise being prepared and delivered pursuant to the custody rule.
• Quarterly-Statement Rule: Rule 211(h)(1)-2
  
  Registered investment advisers to private funds are required to provide quarterly reports to fund investors that include:
  • A table of private fund fees and expenses, including detailed accountings of (a) all compensation (including performance-based compensation) allocated or paid to the investment advisers and their related persons by the private fund client, (b) all fees and expenses allocated to or paid by the private fund client, such as organizational, accounting, legal, administration, audit, tax, due diligence and travel fees and expenses, and (c) any amounts of offsets or rebates carried forward to reduce future payments or allocations to the investment adviser and its related persons,
  • A table of the private fund’s covered portfolio investments, including a detailed accounting of all portfolio investment compensation paid to the investment adviser and related persons, and
  • Fund-level standardized performance information, including disclosures of the criteria used and assumptions made in calculating performance.
  
  Each quarterly statement must include prominent disclosure regarding the manner in which all expenses, payments, allocations, rebates, waivers, and offsets are calculated, and it must include cross references to the sections of the private fund’s organizational and offering documents that set forth the applicable calculation methodology. These reporting requirements also must distinguish between liquid funds (e.g., hedge funds) and illiquid funds (e.g., private equity funds) and establish different standards for each type of fund.
• Adviser-Led Secondaries Transactions Rule: Rule 211(h)(2)-2
  
  Adviser-led secondary transactions are defined as transactions initiated by the private fund adviser or any related person that offers the private fund client’s investors the choice between (a) selling their interests in that private fund and (b) converting or exchanging their interests in the private fund for interests in another vehicle advised by the investment adviser or its related persons. In a change from the Proposed Rules, under the Adopted Rules tender offers generally are now excluded from the definition of an adviser-led secondaries transaction.
  
  In connection with any adviser-led secondary transaction, a registered investment adviser to a private fund client is required to obtain and distribute to investors either (a) a fairness opinion (i.e., a written opinion stating that the price being offered to the private fund for the assets being offered is fair) or (b) a valuation opinion (i.e., a written opinion stating a value or range of values of the assets being sold) from an independent opinion provider. The adviser also is required to distribute a summary of any material business relationships the adviser has, or has had within the prior two years, with the independent opinion provider.
• Additional Record Keeping Requirements: Rule 204-2
  
  The Adopted Rules include amendments to Rule 204-2 (the “books and records rule”) under the Advisers Act to require registered investment advisers to retain certain books and records prepared in connection with the preferential treatment rule (discussed below), the quarterly-statement rule (including documentation substantiating the investment adviser’s determination that a private fund client is an illiquid fund or a liquid fund), the audit rule (including documentation of the steps taken to cause a private fund client that the investment adviser does not control, is not controlled by, and is not under common control with, to undergo a financial statement audit), and the adviser-led secondaries rule (including a copy of any fairness or valuation opinion).

Adopted Rules applicable to All Investment Advisers to Private Funds

• Restricted Activities Rules: Rule 211(h)(2)-1
  
  All investment advisers to private funds are prohibited from engaging in the following five activities unless they satisfy certain disclosure or investor consent requirements noted below:
  • Adviser Fees and Expenses Associated with a Government/Regulatory Investigation; Disclosure and Investor Consent Required - Charging or allocating to a private fund client fees and expenses associated with an investigation of the investment adviser or its related persons by any governmental or regulatory authority, unless the investment adviser (a) requests each fund investor to consent to such charges and allocations, and (b) a majority in interest of the fund investors who are not related persons of the adviser consents.
    
    An investment adviser, however, is not permitted to charge or allocate such fees expenses if the investigation results in a sanction for a violation of the Advisers Act or its rules, regardless of any disclosure provided or investor consent received.
  • Regulatory and Compliance Fees and Expenses; Examination-Related Fees and Expenses; Only Disclosure Required – Charging or allocating to a private fund client any regulatory or compliance fees and expenses, or fees and expenses associated with an examination, of the investment adviser or a related person, unless the investment adviser distributes to the fund’s investors a written notice of any such fees and expenses within 45 days after the end of the fund’s fiscal quarter in which the charges or allocations occur.
  • Reductions in the Amount of an Investment Adviser’s Clawback; Only Disclosure Required – Reducing the amount of an investment adviser’s clawback by actual, potential, or hypothetical taxes applicable to the investment adviser or its related persons or their respective owners, unless the investment adviser distributes written notice to the fund’s investors setting forth the aggregate dollar amounts of the clawback before and after any reduction, within 45 days after the end of the fund’s fiscal quarter in which the adviser clawback occurs.
  • Non-Pro Rata Charges and Allocations of Portfolio Investment Expenses; Only Disclosure Required – Charging or allocating to a private fund client fees and expenses relating to a portfolio investment or potential portfolio investment on a non-pro rata basis when more than one private fund and other clients of the investment adviser or its related persons invest in, or propose to invest in the portfolio investment or potential portfolio investment, unless (a) the non-pro rata charge or allocation is fair and equitable under the circumstances and (b) prior to charging or allocating such fees and expenses to the private fund client, the investment adviser distributes to each fund investor written notice of the charge or allocation and a description of how it is fair and equitable under the circumstances.
  • Borrowing and Loans of Private Fund Assets; Disclosure and Investor Consent Required – Borrowing private fund client assets or receiving a loan or an extension of credit from a private fund client, unless (a) the investment adviser distributes to each fund investor a description of the material terms of the arrangement and (b) receives the consent of a majority in interest of the private fund investors who are not related persons.
• Preferential Treatment: Rule 211(h)(2)-3
  
  All investment advisers to private funds are prohibited from providing individual fund investors with certain specific preferential rights, unless the investment advisers satisfy certain conditions, or more generally, unless they provide disclosure to prospective and current investors as noted below:
  • Preferential Redemption Rights; Conditions – Granting an investor the ability to redeem its interests in a private fund client on terms that the investment adviser reasonably expects to have a material, negative effect on the other investors in the private fund client or a similar pool of assets (e.g., a related fund or another private fund client following a similar strategy), unless (a) such ability to redeem is required by applicable law to which the investor or the private fund is subject or (b) the investment adviser has offered, and will continue to offer, the same rights to current and future fund investors and investors in a similar pool of assets, without qualification.
  • Preferential Information Rights; Conditions – Providing to a fund investor information regarding the portfolio holdings or exposures of a private fund client or a similar pool of assets if the investment adviser reasonably expects that providing such information to the fund investor would have a material, negative effect on the other investors in the private fund or in a similar pool of assets,unless the investment adviser offers the information to all other existing investors in the private fund and any similar pool of assets at or about the same time.
  • Other Preferential Rights; Disclosure – Providing any preferential treatment to any fund investor, unless the investment adviser also provides (a) to prospective investors, advance written notice of any material economic terms regarding the preferential treatment that the investment adviser or a related person provides to other investors in the same fund, and (b) to current fund investors, (i) either at the close of the private fund client's capital raising period (in the case of an illiquid fund) or following the investor’s investment in the fund (in the case of a liquid fund), written disclosure of all preferential treatment the adviser or a related person provides other investors in the same private fund, and (ii) at least annually, information regarding preferential treatment provided by the investment adviser or a related person to other investors in the private fund since the last written notice under the preferential treatment rule.

Adopted Rule applicable to all Registered Investment Advisers

• Compliance Rule - The Adopted Rules also include an amendment to the Advisers Act compliance rule, Rule 206(4)-7, which requires that all SEC-registered investment advisers document in writing, no less frequently than annually, the adequacy of their compliance policies and procedures and the effectiveness of their implementation. The Adopting Release notes that the written documentation requirement is intended to be flexible and does not state specific elements that an adviser must include in the written documentation.

  

• Legacy Status (“Grandfathering”) Provisions
  
  The Adopted Rules extend legacy status to governing agreements entered into before the compliance date if the parties to those agreements would have to amend them with respect to either of the following two rules:
  • Preferential Treatment Rule – The prohibitions in the preferential treatment rule relating to preferential redemption and information rights.
  • Restricted Activities Rules Requiring Investor Consent – The prohibitions in the restricted activities rules requiring investor consent, that is, the prohibitions relating to borrowing from a private fund and charging a private fund investigation fees and expenses, however, legacy status does not extend to the prohibition of charging fees and expenses relating to an investigation that results in the imposition of a sanction for violating the Advisers Act.

Sullivan initial observations on the Adopted Rules

• Limiting and/or Eliminating Liability - The SEC did not adopt a proposed rule that would have prohibited an investment adviser seeking from a private fund client or its investors reimbursement, indemnification, exculpation or a limitation of liability for a breach of fiduciary duty, willful misfeasance, bad faith or negligence, in part because the SEC, after further consideration, did not believe it was necessary. Instead, the SEC provided what it described as additional analysis and clarification. In the next few weeks, Sullivan will be looking closely at this issue to determine the implications of the SEC’s additional analysis and clarification in light of its prior SEC guidance on investment adviser fiduciary duties and waivers of liability.
• Considerations for Non-U.S. Investment Advisers of Private Funds
  • The SEC reiterated that, consistent with its application of other provisions of the Advisers Act, the quarterly-statement rule, the audit rule and the adviser-led secondaries rule do not apply to non-U.S. private funds managed by SEC-registered investment advisers whose principal office and place of business is outside of the U.S., even if the non-U.S. private funds have U.S. investors.
  • The restricted-activities rules and the preferential-treatment rule, however, do apply to non-U.S. private funds managed by SEC-registered offshore investment advisers, as well as by non-SEC registered offshore investment advisers, such as offshore exempt reporting advisers and foreign private advisers.
• Record Retention of Data on Prospective Investors in Offshore (Non-U.S.) Private Funds - Application of the new record-retention rules to prospective non-U.S. investors in a private fund may conflict with the private fund’s obligations under the data protection and marketing rules of other jurisdictions, such as the E.U.’s General Data Protection Regulation (GDPR). In the Adopting Release, the SEC acknowledged this apparent conflict but essentially moved forward with its rule amendments without further addressing it. This issue will likely require additional analysis.
• Application to Non-SEC Registered Investment Advisers – Those restricted activities rules and the preferential treatment rule apply not only to SEC-registered investment advisers and exempt reporting advisers (i.e., private fund advisers and venture capital fund advisers) but also to any unregistered investment adviser providing investment advice to a private fund, including state-registered investment advisers, investment advisers relying on the intra-state exemption, and, as noted above, foreign private advisers.
• Custody Rule Independent-Verification Option – We expect the new audit rule to effectively eliminate the independent-verification option for SEC-registered investment advisers to private funds under the Advisers Act’s custody rule, Rule 206(4)-2(a)(4). We also note that the SEC has pending proposed amendments to the Advisers Act’s custody rule, including amendments to the provisions relating to audits of financial statements. As the audit requirement in the Adopted Rules is intended to align with the custody rule’s audit provisions, amendments to the custody rule are likely to affect audits required under the new audit rule.
• Preferential Treatment and “Similar Pool of Assets” - The preferential treatment rule requires consideration of the treatment of investors to a single fund, that is, the private fund itself, as well as to a “similar pool of assets.” The definition of a similar pool of assets is very broad, and it includes not only other feeder and parallel funds, but also co-investment vehicles and potentially joint venture structures with investments by multiple clients as well as funds whose strategies only partially overlap with the private fund client's strategy. Investment advisers will potentially have to consider all investment products when negotiating side letters and other arrangements.
• Legacy Status (“Grandfathering”) Provisions – The legacy-status provisions of the Adopted Rules apply only in the context of the preferential treatment rule and the restricted activities rules. Moreover, unlike other grandfathering provisions, which typically either exclude existing funds and contractual agreements from the application of new requirements or extend the date for full compliance, the preferential-treatment rule and restricted activities rules generally apply to most private funds and contractual agreements (e.g., a private fund’s operating or organizational agreements, subscription agreements and side letters, as well as loan documents, promissory notes and credit agreements) that commenced prior to the compliance date, unless compliance with the Adopted Rules requires amendments to the fund’s governing documents or other agreements. Investment advisers will need to carefully consider their fund governing documents and other agreements to determine the applicability of those legacy provisions.