On August 23, 2023, the U.S. Securities and Exchange Commission (“SEC”), by a party-line vote of 3-2, adopted new rules applicable to investment advisers to private funds (“Private Fund Advisers”) that address transparency, conflicts of interest and governance mechanisms (“PFA Rules”). While the SEC determined not to adopt certain of the more controversial provisions that had been proposed, the final PFA Rules nonetheless reflect an ambitious set of reforms for the $26.6 trillion private funds industry that are likely to spur various legal challenges. As we continue to review and assess the impact of the PFA Rules on our clients, the following alert is intended to provide a high-level overview of the main substantive points of the PFA Rules.
It is worth noting that while most of the substantive provisions of the Investment Advisers Act of 1940 (“Advisers Act”) apply only to registered investment advisers, a number of the PFA Rules—those pertaining to restricted activities and preferential treatment among investors—will also apply to Private Fund Advisers that file as exempt reporting advisers (“ERAs”) in reliance on exemptions for smaller advisers solely to private funds and advisers solely to venture capital funds.
Rules Applicable to All Private Fund Advisers (including ERAs)
Private Fund Adviser Restricted Activities
Under the PFA Rules, all Private Fund Advisers are prohibited from taking the following actions with respect to any private fund they advise without providing certain notices and, in some cases, obtaining investor consent:
- Charging of Investigation Expenses. Fees or expenses associated with any government or regulatory investigation of the Private Fund Adviser (or its related persons) cannot be charged to a private fund without first obtaining written consent from at least a majority in interest of the private fund’s investors. Further, in no event will a Private Fund Adviser be permitted to charge such fees or expenses if they relate to an investigation that results in the imposition of a sanction for a violation under the Advisers Act.
- Charging of Regulatory and Compliance Fees and Expenses. In addition to the notice and consent required with respect to investigation costs, Private Fund Advisers charging general regulatory or compliance expenses to a private fund (including fees or expenses associated with an examination) must distribute to investors a written notice describing the nature and amount of such expenses within 45 days after the end of the fiscal quarter in which the charge occurs.
- Reducing Clawbacks for Taxes. A Private Fund Adviser may not reduce a clawback by the amount of any actual, potential or hypothetical taxes applicable to the Private Fund Adviser, its related persons or their respective owners or interest holders without distributing a written notice to investors setting forth the amount of the clawback both before and after the reduction within 45 days after the end of the fiscal quarter in which the clawback occurs. 
- Allocating Fees and Expenses Among Fund Vehicles on a Non-Pro Rata Basis. If a Private Fund Adviser wishes to allocate expenses related to a portfolio investment (or potential portfolio investment) among one or more private funds or other clients that it or a related person advises on a non-pro rata basis, the Private Fund Adviser must first distribute to investors a written notice supporting their determination that the non-pro rata allocation is fair and equitable under the circumstances.
- Borrowing from a Private Fund. A Private Fund Adviser may not borrow money, securities or other assets from a private fund client without first obtaining written consent from at least a majority in interest of the private fund’s investors.
In connection with any of the required notices or consents described above, if a given fund investor is itself a pooled vehicle controlled by or otherwise affiliated with the Private Fund Adviser, the Private Fund Adviser is required to look through such vehicle and deliver the applicable notice or consent request directly to the ultimate investors.
Prohibition Against Preferential Redemption Rights and Preferential Information
Under the PFA Rules, all Private Fund Advisers are prohibited from granting preferential treatment to select investors (pursuant to side letters or otherwise) with respect to redemption rights or the provision of information, except in certain limited circumstances.
- Prohibition Against Preferential Redemption Rights. A Private Fund Adviser may not grant an investor in a private fund 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 unless (i) the ability to redeem is required by applicable law or regulation, or (ii) such redemption ability is offered to all other investors in the private fund.
- Prohibition Against Preferential Information. A Private Fund Adviser may not provide to a given private fund investor information regarding the portfolio holdings or exposures of the private fund unless (i) it provides such information to all investors in such private fund, or (ii) it does not reasonably expect that providing the information would have a material, negative effect on such other investors.
Notice Requirement for All Other Preferential Treatment
A Private Fund Adviser may not provide any preferential treatment to an investor in a private fund (pursuant to side letters or otherwise) without providing the following written notices:
- Advance Notice for Prospective Investors. Any prospective investor must receive, prior to investing in a private fund, notice of any preferential treatment granted to other investors with respect to material economic terms of the fund.
- Notices for Current Investors. Current investors in any “illiquid fund” must receive, as soon as reasonably practicable following the end of the fund’s fundraising period, written disclosure of all preferential treatment granted to other investors in the same private fund. Current investors in any “liquid fund” must receive such disclosure as soon as reasonably practicable following their investment in the fund.
- Annual Notice. On at least an annual basis, all investors in a private fund must receive written notice regarding any preferential treatment provided by the private fund since the delivery of the last such notice, if any.
Rules Applicable to Registered Private Fund Advisers Only
While many Private Fund Advisers already provide some form of quarterly reporting to investors, the PFA Rules now mandate the timing and content of such quarterly reports for registered Private Fund Advisers. Quarterly reports generally are required to be distributed to investors within 45 days after the end of the first three fiscal quarters of the year, and 90 days after the end of the fourth fiscal quarter of the year. The content of the reports must be presented in a table format and include, at a minimum, a detailed line-item accounting of the following information for the prior quarterly period:
- Fund-level compensation paid or allocated to the Private Fund Adviser or its related persons, all other expenses allocated to or paid by the fund, and the impact of any fee offsets or rebates on the foregoing, without permitting exclusion of de minimis amounts, the general grouping of smaller expenses into broad categories, or the labeling of any amounts as miscellaneous;
- Portfolio investment-level compensation paid or allocated to the Private Fund Adviser or its related persons, as applicable, and the impact of any fee offsets or rebates on the foregoing;
- Prominent disclosure regarding the manner in which expenses, payments, allocations, rebates, waivers and offsets are calculated, with cross-references to the relevant sections of the private fund’s offering documents that set forth the applicable calculation methodology.
In addition to reporting on fees and expenses, the PFA Rules also require quarterly reports to include standardized performance information, the contents of which depend on whether the private fund is liquid or illiquid.
- Liquid Funds: net total returns on an annual basis for the 10 fiscal years prior to the quarterly statement date or since the fund’s inception (whichever is shorter), average net total returns over one-, five-, and 10-year periods, and the cumulative net total return for the current fiscal year as of the end of the most recent fiscal quarter.
- Illiquid Funds: internal rate of return and multiple on invested capital since inception on a gross and net basis, calculated with and without the impact of any fund-level subscription facility borrowing, with gross calculations broken down to show realized and unrealized performance separately.
The foregoing performance information must be accompanied by prominent disclosure within the quarterly report itself of the criteria used and any assumptions made in performing the performance calculations.
The PFA Rules require registered Private Fund Advisers to cause each private fund they advise to undergo an annual audit in accordance with U.S. generally accepted accounting principles that is conducted by an independent public accountant subject to the oversight of the Public Company Accounting Oversight Board. Audited financial statements must be delivered to investors within 120 days of the private fund’s fiscal year end as well as promptly upon the fund’s liquidation. The new audit requirement effectively requires all registered Private Fund Advisers, regardless of whether they maintain “custody” of private fund client assets for Advisers Act purposes, to comply with the annual audit requirement of the Advisers Act custody rule in respect of the private funds they advise.
Adviser-Led Secondary Transactions
The PFA Rules require registered Private Fund Advisers engaging in an adviser-led secondary transaction to provide certain information to private fund investors. First, the adviser must obtain either a fairness opinion or a valuation opinion regarding the secondary transaction from an independent opinion provider. Second, the adviser must prepare and distribute a summary of any material business relationships between the adviser or its related persons and the independent opinion provider that have existed during the two years prior to the fairness opinion or valuation opinion being issued. Both the fairness opinion or valuation opinion and the summary of material business relationships must be distributed to investors prior to the due date of the election form for the adviser-led secondary transaction.
Books and Records
Under the PFA Rules, registered Private Fund Advisers must keep books and records that demonstrate compliance with the quarterly reporting, audit and adviser-led secondary transaction requirements. Generally, copies of all reports or disclosures distributed as well as a record of each recipient and corresponding distribution dates must be maintained. With respect to quarterly reports, the PFA Rules also require registered Private Fund Advisers to make and retain all records that (i) show the methodology used to calculate all expenses, payments, allocations, rebates, offsets, waivers and performance figures included in the quarterly reports, and (ii) substantiate the adviser’s determination that a private fund is either liquid or illiquid.
Annual Compliance Review Documentation
The PFA Rules also amend the Advisers Act to require all registered investment advisers (not only registered Private Fund Advisers) to document in writing the annual review of their compliance policies and procedures. Under the Advisers Act, registered investment advisers already are required to assess on at least an annual basis whether the compliance policies and procedures that have been implemented are being followed and whether any changes are needed in order to remain in compliance with the Advisers Act, whether due to changes in the adviser’s business or any compliance matters that arose in the prior year. The PFA Rules make clear that the added documentation of the annual review process will provide SEC staff with visibility into an adviser’s compliance practices as part of their routine examinations.
A Note on “Hedge Clauses” and Waivers of Fiduciary Duties
In what was initially viewed as a welcome relief to Private Fund Advisers, the SEC decided not to adopt as part of the final PFA Rules the proposed prohibition against Private Fund Advisers seeking reimbursement, indemnification, exculpation or limitation of liability from private funds or their investors for a breach of fiduciary duty, willful misfeasance, bad faith, negligence, or recklessness on the part of the adviser or its related persons in performing services under a private fund’s operating agreement (collectively, “hedge clauses”). However, the SEC instead stated its view that Federal antifraud liability under the Advisers Act for breach of fiduciary duty applicable to all Private Fund Advisers cannot be waived—even by institutional clients—and that a Private Fund Adviser can breach its Federal fiduciary duty through simple negligence alone. Accordingly, depending on the facts and circumstances, a hedge clause in an agreement with an institutional client may violate the Advisers Act’s antifraud provisions, such as when the hedge clause (i) waives any and all of the Private Fund Adviser’s fiduciary duties or (ii) explicitly or generically waives the Private Fund Adviser’s Federal fiduciary duty, and in each case there is no “savings clause” language to the effect that the adviser is not waiving its Federal fiduciary duty or that the client retains certain non-waivable rights.
Compliance Deadlines and Legacy Status
Compliance deadlines for the PFA Rules vary by requirement and, in some cases, size of the Private Fund Adviser as follows:
Notwithstanding the foregoing, certain requirements of the PFA Rules applicable to all Private Fund Advisers (including ERAs) do not apply in respect of any private fund governing agreements that were entered into prior to the applicable compliance deadlines noted above if the parties would be required to amend the agreements and the private funds governed by those agreements have commenced operations as of the applicable compliance dates. Such “legacy status” specifically applies to (i) the charging of investigation expenses restriction (other than in respect of an investigation that results in the imposition of a sanction for a violation under the Advisers Act), (ii) the borrowing from a private fund restriction, and (iii) the prohibition against providing preferential redemption rights and information.
 A “private fund” is an investment vehicle that is exempt from registering under the Investment Company Act of 1940, as amended, pursuant to section 3(c)(1) or section 3(c)(7) thereof. In general, the PFA Rules do not apply to investment advisers in respect of any securitized asset funds they advise, other than in respect of the annual compliance review documentation requirement applicable to all registered investment advisers.
 As originally proposed, the PFA Rules included a flat prohibition on these activities, with no exceptions for notice or consent.
 For the purposes of determining a “majority in interest,” all related persons of the Private Fund Adviser are excluded. Additionally, a Private Fund Adviser is required to request consent from all investors in the private fund, which prevents an adviser from being able to comply by notifying only a small subset of investors that happen to represent a majority of the fund’s capital.
 A clawback provision is targeted at restoring funds to investors in certain cases where excess performance compensation has been received. The SEC notes in the adopting release that they did not opt for a rule that would mandate the inclusion of a clawback mechanism in fund documents.
 The PFA Rules do not set forth a definition of “pro rata” for these purposes in an effort to provide some flexibility in determining methods for pro rata allocations.
 As with the consent requirement for investigation expenses, the Private Fund Adviser is required to request consent from all investors in the private fund, and any related persons of the Private Fund Adviser are excluded for purposes of determining a “majority in interest”. In both instances, a fund’s governing documents may provide for a higher (i.e., supermajority) consent threshold.
 For purposes of the preferential treatment rules, references to a given private fund typically include any other “similar pool of assets.” The adopting release notes that this is to prevent advisers from circumventing the limitations on preferential treatment by setting up parallel funds or similar structures, but advisers to multiple funds will need to work closely with counsel to ensure that such funds are not inadvertently treated as “similar pools of assets” for these purposes.
 The PFA Rules do not set out to define what constitutes a “material economic term,” but the SEC’s adopting release does include provisions related to the cost of investing, liquidity rights, fee breaks, and co-investment rights as examples of material economic terms.
 An “illiquid fund” is a private fund that (i) is not required to redeem interests upon an investor’s request and (ii) has limited opportunities, if any, for investors to withdraw before termination of the fund.
 A “liquid fund” is any private fund that is not an illiquid fund. The SEC declined to establish a third category for “hybrid funds” or allow Private Fund Advisers to determine the classification of a fund.
 For Private Fund Advisers to fund-of-funds, the reporting deadlines are extended to 75 days and 120 days, respectively.
 The first quarterly reporting period for a new private fund may cover its first two full fiscal quarters of operating results.
 With respect to any private fund that does not invest in portfolio companies that pay or allocate any fees to the Private Fund Adviser or its related persons (e.g, a hedge fund that invests in public market securities), this reporting requirement would not be applicable.
 In a departure from the proposal, the final PFA Rules do not require the portfolio investment table to include a list of the private fund’s ownership percentage of each covered investment.
 “Internal rate of return” is defined to mean the discount rate that causes the net present value of all cash flows throughout the life of the private fund to be equal to zero. “Multiple on invested capital” is defined to mean (i) the sum of (a) the unrealized value of the illiquid fund, and (b) the value of all distributions made by the illiquid fund, (ii) divided by the total capital contributed to the illiquid fund by its investors.
 Illiquid fund performance reporting must also include a statement of contributions to and distributions from the fund.
 Private Fund Advisers may treat special purposes vehicles established to facilitate investments for legal, tax, regulatory or other similar purposes as a separate client for purposes of the audit rule, or combine such vehicle’s assets with the assets of the pooled private fund vehicle.
 In a departure from the proposal, the final PFA Rules do not require an auditor to notify the SEC (i) promptly upon issuing an audit report to a private fund that contains a modified opinion or (ii) within four business days of resignation or dismissal from, or other termination of, the engagement with the private fund, or upon removing itself or being removed from consideration for being reappointed.
 For Private Fund Advisers to fund-of-funds, the distribution deadline is extended to 180 days, consistent with SEC staff guidance under the custody rule.
 The PFA Rules also require any sub-adviser to a private fund that is unaffiliated with the fund’s Private Fund Adviser to take all reasonable steps to cause the fund to undergo an audit that satisfies the new requirement.
 An “adviser-led secondary transaction” is defined as a transaction in which a Private Fund Adviser or its related persons offer a private fund’s investors the choice between (i) selling all or a portion of their interests in the private fund and (ii) converting or exchanging all or a portion of their interests in the private fund for interests in another vehicle advised by the Private Fund Adviser or any of its related persons.
 As originally proposed, the PFA Rules did not allow for a valuation opinion to be provided in lieu of a fairness opinion.
 Whether a business relationship is “material” requires a facts and circumstances analysis, although audit, consulting, capital raising, investment banking, and other similar services would typically meet the standard.
 In 2019, the SEC issued an interpretation finding that all investment advisers (including ERAs), as fiduciaries to their clients, owe a duty of care and duty of loyalty to their clients under the Advisers Act.
 The SEC declined to opine on waivers of fiduciary duties that may exist under state law, but noted that to the extent a hedge clause is unclear as to whether it applies to the Federal fiduciary duty, state fiduciary duties or both, the SEC will interpret the hedge clause as waiving the Federal fiduciary duty.