The Securities and Exchange Commission (SEC) has adopted the most significant changes to regulating private funds and private fund advisors since 2010.

The changes expand the scope of disclosure, reporting and other obligations on private fund advisors. The changes also restrict several common practices.

Private fund advisors should develop a plan to comply well in advance of the deadlines. Here’s what you should know:

Components

• Private fund advisors, including exempt reporting advisors and other unregistered investment advisors, face restrictions on:
  • Activities such as recouping certain expenses and borrowing arrangements with funds.
  • Preferential treatment of investors.
• SEC-registered private fund advisors must:
  • Conduct an annual audit.
  • Distribute quarterly statements.
  • Comply with certain conditions to advisor-led secondaries.

Compliance Dates

• Quarterly statement and private fund audit rules: SEC-registered private fund advisors must comply with these requirements within 18 months of the Federal Register publication date (expected this month).
• Advisor-led secondaries, preferential treatment and restricted activities rules:
  • Private fund advisors with $1.5 billion or more in assets under management attributable to private funds must comply with these requirements within 12 months of the Federal Register publication date.
  • Private fund advisors with less than $1.5 billion in assets under management attributable to private funds must comply with these requirements within 18 months of the Federal Register publication date.

Legacy Status

Compliance regarding certain aspects of the rules will be subject to grandfathering or “legacy status” with respect to existing private funds managed by private fund advisors (discussed below).

Certain Exemptions

The rules do not apply to offshore private fund advisors (regardless of SEC registration status) with respect to offshore funds, whether or not those funds have U.S. investors.

In addition, advisors to private funds whose primary purpose is to issue asset-backed securities and whose investors are primarily debt holders are not subject to the rules.

Rules Relating to All Private Fund Advisors (Including Exempt Reporting Advisors and Other Unregistered Investment Advisors)

• Restrictions on certain activities:
  • The rules restrict private fund advisors from:
    • Charging or allocating to the private fund fees and expenses relating to an investigation of the private fund advisor (or related persons) by regulatory authorities, absent written consent from investors. However, irrespective of consent, the rules prohibit private fund advisors from charging fees/expenses stemming from an investigation that results in sanctions for violating the Advisors Act or related rules.
    • Charging or allocating to the private fund any regulatory, compliance or examination expenses of the private fund advisor (or related persons), unless such expenses are disclosed in writing to investors within 45 days of the end of the quarter in which they were incurred.
    • Reducing the amount of a private fund advisor’s (or a related person’s) clawback by actual, potential or hypothetical taxes, unless the advisor discloses in writing the aggregate dollar amounts of the advisor clawback, before and after any such reduction, within 45 days of the end of the quarter in which the clawback occurs.
    • Charging or allocating to the private fund fees and expenses relating to a private fund portfolio investment held by multiple funds on a non-pro rata basis, unless the charge or allocation is fair and equitable under the circumstances and the private fund advisor first distributes a written notice describing the allocation and how it is fair and equitable.
    • Borrowing money, securities or other private fund assets, or receiving a loan or extension of credit from a private fund, unless the private fund advisor distributes a written description of the material terms of the proposed borrowing to investors and obtains their written consent. This prohibition will not prevent advisors from borrowing from investors outside of the fund.
    • The rules do not prohibit charging a portfolio company for services the private fund advisor does not provide, such as accelerated monitoring fees (as was initially proposed). The SEC stated that the federal fiduciary duty owed by private fund advisors to private fund clients already prohibits such practice.
  • Certain Grandfathering: Private funds that began operations prior to the applicable compliance date will not be required to comply with the two restrictions listed above requiring investor consent (i.e., charging fees and expenses from regulatory investigations and borrowing from a private fund). However, legacy status does not permit a private fund advisor to charge or allocate fees and expenses related to an investigation that results in a sanction for violating the Advisors Act or associated rules.
• Restrictions on preferential treatment:
  • Private fund advisors generally are prohibited from providing preferential redemption rights or information regarding portfolio holdings or exposures to an investor (or an investor in a similar pool of assets) if such preferential treatment would reasonably be expected to have a material, negative effect on other investors.
    • Limited exceptions are available where redemption rights are required by law or where redemption or information rights are offered to current and future investors in the private fund (and any similar pool of assets).
    • The SEC provided legacy status to funds with respect to the above prohibitions for agreements entered into prior to the applicable compliance date.
  • All forms of preferential treatment are subject to requirements for written disclosure to investors, including:
    • Advance Written Notice Regarding Economic Terms: A private fund advisor must disclose to each prospective investor, prior to the investor’s investment, all preferential treatment related to “material economic terms” the advisor has provided to other investors in the same fund.
    • Prompt Notice to Existing Investors: A private fund advisor must disclose to each investor all preferential treatment the advisor has provided to other investors in the same fund.
      • For illiquid funds, disclosure must be made as soon as reasonably practicable following the end of the private fund’s fundraising period.
      • For liquid funds, disclosure must be made as soon as reasonably practicable following the investment.
    • Annual Notice to Existing Investors: A private fund advisor must deliver to investors an annual notice of any preferential treatment provided since the last notice.
  • SEC Commissioner Caroline A. Crenshaw said in a statement that “relying on the parties’ sophistication alone, in the absence of regulation, will continue to leave investors exposed to unfair or harmful practices.”
    • The disclosure requirements will fundamentally change a private fund’s current “most favored nations” (MFN) practices.

      First, private fund advisors will no longer be permitted to only disclose other investors’ side letter provisions to investors with MFN provisions. Although the rules require only disclosure of key terms, some investors receiving such disclosure may ask to be contractually provided with key terms, particularly if the terms have been provided to similarly situated investors.

      Second, private fund advisors to closed-end funds will no longer be permitted to solely implement the MFN election process after the fund’s final closing.

    • The disclosure requirements will not be subject to grandfathering (i.e., existing funds will not be entitled to “legacy status”). Older funds will need to disclose preferential treatment granted but not yet disclosed.

Rules Relating Only to SEC-Registered Private Fund Advisors

Audit requirements: SEC-registered private fund advisors must undergo a financial statement audit and deliver audited financial statements to investors consistent with the audit exception in Rule 206(4)-2 under the Advisors Act.

• Distribution of quarterly statements: SEC-registered private fund advisors must distribute quarterly statements to private fund investors that include:
  • A “fund table” detailing all compensation paid or allocated to the advisor and related persons, fund fees and expenses and any fee offsets or rebates during the reporting period.
  • A “portfolio investment table” that includes a detailed accounting of all compensation paid or allocated by a private fund’s portfolio investments to the advisor.
  • Expense calculation disclosures, including the methodology used to calculate fund fees and expenses.
• Standardized performance information: The form and content will vary depending on whether a fund is “liquid” or “illiquid.” The SEC says liquid funds generally allow periodic investor redemptions and primarily invest in market-traded securities and therefore determine their net asset value regularly.
• Conditions to advisor-led secondaries: The rules prohibit advisor-led secondary transactions by an SEC-registered private fund advisor unless the advisor distributes the following two items to investors before they are required to respond to a request to participate in the transaction:
  • An independent “fairness opinion” that the offered price is fair or that states the value or range of values of the assets to be sold.
  • A summary of material business relationships the advisor (or its related persons) has with the independent opinion provider.

Recordkeeping and Compliance Rule Amendments

The SEC amended Rule 204-2 under the Advisors Act to require SEC-registered private fund advisors to maintain certain documents relating to the rules.

• Unrelated to the other changes, the SEC updated Rule 206(4)-7 to require registered investment advisors (including those who do not manage private funds) to document annual reviews of compliance policies and procedures.

Lawsuit Against the SEC

• On September 1, 2023, six trade associations representing private fund and loan syndication firms asked the United States Court of Appeals for the Fifth Circuit to hold the new rules unlawful. The suit argues that “the [SEC] has not shown any need for the intrusive rules it has adopted [as] investors in private funds are among the largest, most sophisticated investors in the world and include the world’s largest sovereign wealth funds, pension funds, professionally managed university endowments and charitable foundations.”