The Proposed Rules included a list of “prohibited” activities. The Final Rules do not flatly prohibit such activities but instead generally restrict certain activities, unless certain disclosures are made to, or, in some cases, consent is obtained from, private fund investors. These restrictions relate to transactions involving conflicts of interest, compensation schemes and fund borrowing. Despite the SEC’s reclassification from “prohibited” to “restricted” activities, the SEC retained one prohibition regarding the allocation of certain investigation fees and expenses as noted below. The Final Rules otherwise allow for such activities so long as the adviser satisfies the applicable disclosure or consent conditions.

ERAs and SIAs should pay particular attention to these new requirements, as the substance of the Final Rules has not historically applied to them. The application of such substantive regulation to ERAs and SIAs represents a significant change in the regulatory obligations and burden for ERAs and SIAs. As originally contemplated under Dodd-Frank, ERAs and SIAs were not to be subject to substantive Federal regulation – other than general antifraud principles and “skinny” reporting requirements.

Under the Final Rules, the following activities/practices are restricted for any RIA, ERA or SIA, regardless of whether such activities/practices are permitted under a private fund’s governing documents, applicable state law, or contractual arrangements with investors.

Broken Deal Expenses

The SEC did not make a distinction between fees/expenses of consummated investments and unconsummated investments (i.e., “broken deal expenses”). In the Proposed Rules, the SEC stated that to the extent a potential co-investor does not have a binding obligation to participate in a transaction, the proposed rule would not prohibit the allocation of expenses attributable to such potential co-investor to a private fund that would have participated in the transaction (subject to disclosure of such costs in the private fund’s offering documents). The SEC did not provide any indication that this prior position was limited or changed as part of the Final Rules. As such, arrangements that provide for the allocation of broken deal expenses to a “main fund” are likely permissible under the Final Rules if properly disclosed and permitted under the applicable governing documents. However, advisers will still be required to disclose any broken deal expenses in quarterly statements, and the allocation of such expenses may still be subject to the “fair and equitable” standard under the Final Rules.

Proposed Adviser Misconduct Prohibitions

In the Final Rules, the SEC did not adopt their proposed prohibitions on advisers (a) charging a portfolio investment for monitoring, services, consulting, or other fees that the adviser does not, or does not reasonably expect to, provide to the portfolio investment, and (b) obtaining reimbursement, indemnification, exculpation, or limitation of its liability by the private fund or its investors related to a claim of breach of fiduciary duties, willful malfeasance, bad faith, negligence, or recklessness.

The SEC indicated that such prohibitions were unnecessary because such activities are generally contrary to an adviser’s fiduciary duties and the antifraud provisions under the Advisers Act that are already applicable to advisers, including ERAs and SIAs. In addition, the SEC reiterated its position that an adviser’s fiduciary duties under the Advisers Act cannot be waived by agreement and any such waiver would be a violation under the Advisers Act. The SEC explicitly notes that it does not take a position with respect to the scope or substance of any state law fiduciary duty. However, to the extent that any waiver clause is unclear as to whether such waiver applies to the Advisers Act fiduciary duty, state law fiduciary duty, or both, the SEC will interpret such clause as a waiver of the Advisers Act fiduciary duties. Therefore, advisers should evaluate any waiver, indemnification or exculpation clauses to clarify their application to avoid any foot-fault violations under the Advisers Act.

Preferential Treatment Rule

The Final Rules prohibit any RIA or ERA from granting preferential terms to an investor in any private fund that the adviser reasonably expects to have a material, negative effect on other investors in such private fund or a similar pool of assets managed by the adviser or its related persons, as set forth in the following:

Pursuant to the Preferential Treatment Rule, no RIA or ERA may grant a preferential term (including any preferential redemption or information reporting rights) to an investor in a private fund, unless the adviser provides the following notices, as applicable:

• Prospective Investors – written disclosure to each prospective investor in a private fund prior to such investor’s investment in the private fund regarding any preferential treatment related to any material economic terms provided to other investors in the same private fund;
• Current Investors – written disclosure to each investor in a private fund of all preferential terms the adviser or its related persons has provided to other investors in the same private fund, (i) in respect of any private fund that is an illiquid fund, as soon as reasonably practicable following the of the private fund’s fundraising period, and, (ii) in respect of any private fund that is a liquid fund, as soon as reasonably practicable following the investor’s investment in the private fund; and
• Annual Notices – written disclosure to each investor in a private fund on an annual basis of any preference terms provided to other investors in the same private fund during the preceding period.

In the release accompanying the Proposed Rules, the SEC stated that a determination of whether any term is “preferential” depends on the facts and circumstances. Advisers should consider consulting with counsel on determinations as to whether any term is preferential and any associated written disclosure. In adopting the Final Rules, the SEC recognized that the Preferential Treatment Rule will disrupt the fund closing process, but relied on speculative efficiencies and benefits to investors that may offset the increased difficulties experienced by advisers.

Adviser-Led Secondaries Rule

The Final Rules require an RIA, prior to completing an “adviser-led secondary transaction” with respect to a private fund, to distribute the following to the private fund’s investors prior to the due date of the investor election form in respect of such transaction: (a) a fairness opinion or valuation opinion from an independent opinion provider; and (b) a written summary of any material business relationships the adviser or any of its related persons has, or has had within the two years immediately prior to the issuance of the fairness opinion or valuation opinion, with the independent opinion provider.

Independent opinion providers are defined to include any entity that (a) provides fairness opinions or valuation opinions in the ordinary course of its business and (b) is not a “related person” of the adviser. The SEC specifically declined to allow for a broader group of opinion providers to meet the definition of independent opinion providers, noting the importance that opinion providers have the necessary experience to value assets in connection with adviser-led secondary transactions.

In its discussion accompanying the Proposed Rules, the SEC indicated that a wide scope of transactions may be covered by this rule, from single asset transactions to full fund restructurings. The Final Rules generally follow the substantive requirements as proposed by the SEC, except that an RIA may obtain a valuation opinion (as an alternative to a fairness opinion), and the deadline for making such required disclosures is based on the due date for the applicable investor election form in respect of any such transaction.

Audit Rule

The SEC declined to adopt the separate but similar audit requirements as previously proposed. The Final Rules require RIAs to cause each private fund they advise to undergo a financial statement audit in compliance with Advisers Act Rule 206(4)-2 (Custody Rule). The Audit Rule, in effect, supplants the Advisers Act surprise examinations alternative to satisfy the Custody Rule. Since most private funds do currently undergo an annual financial statement audit related to the Custody Rule, this portion of the Final Rules should have relatively little impact on advisers. For private funds that an RIA does not control – presumably this would most commonly be a situation where the RIA is a subadviser to the private fund -- the Audit Rule requires an RIA to “take all reasonable steps” to cause any such private fund to (a) undergo an audit in compliance with Custody Rule and (b) deliver financial statements in accordance with the Custody Rule if the private fund does not otherwise undergo such audit.

Quarterly Statement Rule

The Final Rules require an RIA to cause its private fund clients to deliver quarterly statements to investors with minimum disclosures regarding fees, expenses and performance within (i) 45 days after the end of each of the first three fiscal quarters during each fiscal year and (ii) 90 days after the end of each fiscal year. For any private fund client that is a “fund of funds,” the deadlines are extended to 75 days and 120 days, respectively.

The substantive reporting requirements under the Final Rules are substantially similar to those previously proposed by the SEC. As noted below, the performance disclosures vary in part on whether the private fund is an “illiquid fund” (defined in the Final Rules in relation to an investor’s ability to withdrawal/redeem from such private fund, e.g., a private equity fund) or a “liquid fund” (defined in the Final Rules as any private fund that is not a liquid fund, e.g., a hedge fund).

Updating quarterly statement reporting practices and formats to reflect the required information under the Final Rules may present challenges and increased costs to advisers. Advisers should pay careful attention to calculation of performance information with respect to illiquid funds.

Annual Review of Compliance Policies

In addition to the private fund investor protections describe above, the Final Rules also amend rule 206(4)-7 under the Advisers Act to require all registered investment advisers (including SAFIAs and advisers those that do not advise private funds) to document the annual review of their compliance policies and procedures in writing. The Compliance Date for rule 206(4)-7 is November 13, 2023.

As we have in the past, we will continue to monitor these issues and will provide future client updates.