The U.S. Securities and Exchange Commission (SEC) on Aug. 23, 2023, adopted the long-awaited private fund rules (Private Fund Rules) under the Investment Advisers Act of 1940 (Advisers Act) as part of SEC Release No. IA-6383 (Adopting Release).¹ The Private Fund Rules are intended to enhance the regulation of private fund advisers and update the existing compliance rule that applies to all private fund investment advisers (collectively, Advisers), with the stated goal of protecting private fund² investors with increased transparency, competition and efficiency in the market.³

Though significantly pared back from the proposed rules issued in February 2022 (Proposed Rules), the Private Fund Rules will affect SEC-registered Advisers (RIAs)⁴ and Advisers who are considered "exempt reporting advisers" (ERAs)⁵ in a meaningful way.

With respect to RIAs only, the Private Fund Rules implemented the following: 1) the Quarterly Statements Rule, requiring the delivery of quarterly statements to investors detailing the fees, expenses, compensation and performance of the private fund, 2) the Audit Rule, requiring RIAs to conduct an annual audit of each private fund that complies with the Custody Rule under the Advisers Act,⁶ and 3) the Adviser-Led Secondaries Rule, requiring a fairness opinion or a valuation opinion in any Adviser-Led secondary transaction.

The Private Fund Rules also implemented the following with respect to all Advisers: 1) the Restricted Activities Rule, prohibiting Advisers from engaging in certain activity with some disclosure-based exemptions and some consent-based exemptions, and 2) the Preferential Treatment Rule, which a) prohibits Advisers from providing preferential treatment with respect to redemption rights and portfolio holdings or exposure information that the Adviser reasonably expects to have a material, negative effect on other investors, and b) requires disclosure of all other types of preferential treatment.

In addition, the Private Fund Rules implemented the Annual Review Rule, requiring all RIAs to document their annual review component of Rule 206(4)-7 of the Advisers Act in writing, and the Recordkeeping Rule, amending the existing recordkeeping rule to require RIAs to retain books and records related to the Quarterly Statement Rule, Audit Rule, Adviser-led Secondaries Rule and Preferential Treatment Rule.

Rules Applicable Only to RIAs

The Quarterly Statements Rule

The Quarterly Statements Rule⁷ requires RIAs to distribute to investors a quarterly statement that includes certain information regarding fees, expenses and performance of the private funds it advises. Such quarterly statements must be delivered to the fund's investors within 45 days (75 days for fund of funds) after the end of each of the first three calendar quarters and within 90 days (120 days for fund of funds) after the end of each fiscal year.

Disclosure of Fees and Expenses

The quarterly statement must disclose the following to investors in table format:

• RIA Compensation: a detailed accounting of all compensation, fees and other amounts allocated or paid to the RIA or any of its related persons by the private fund during such reporting period
• Fund Expenses: a detailed accounting of all fees and expenses allocated to or paid by the private fund during such reporting period other than RIA Compensation
• Offset Carryforwards: the amount of any offsets or rebates carried forward during the reporting period to subsequent quarterly periods to reduce future payments or allocations to the RIA or its related persons

Disclosure of Portfolio Investment Compensation

In addition, the quarterly statement must include a detailed accounting of all portfolio investment compensation allocated or paid by each covered portfolio investment during the reporting period in a single table. Portfolio investment compensation includes, but is not limited to, origination, management, consulting, monitoring, servicing, transaction, administrative, advisory, closing, disposition, directors, trustees or similar fees, or payments by the covered portfolio investment to the RIA or its related persons.

Cross-References to Organizational and Offering Documents

Each statement in the quarterly statement must include prominent disclosure regarding the manner in which expenses, payments, allocations, rebates, waivers and offsets are calculated, including cross-references to the relevant sections of the fund's offering documents and organizational documents that set forth the applicable methodology.

Performance Disclosure

In addition to the disclosure regarding fees and expenses, this rule requires disclosure of fund performance in each such quarterly statement. For RIAs to liquid funds, the rule requires disclosure of performance based on net total return 1) on an annual basis for the 10 fiscal years prior to such quarterly statement or since the fund's inception (whichever is shorter), 2) over one, five and 10 fiscal year periods, and 3) on a cumulative basis for the current fiscal year as of the end of the most recent fiscal quarter. Net returns are required to be presented, but this rule permits the inclusion of gross returns as well.

For illiquid funds, the rule requires RIAs to disclose the following performance measures, shown since inception of the illiquid fund and computed with and without the impact of any fund-level subscription facilities: 1) gross and net internal rate of return, 2) gross and net multiple of invested capital, and 3) gross internal rate of return and gross multiple of invested capital for the realized and unrealized portions of the illiquid fund's portfolio, with the realized and unrealized performance shown separately. The rule also requires RIAs to provide investors a statement of contributions and distributions for the illiquid fund.

Finally, the different categories of required performance information in the quarterly statement (e.g., net performance and gross performance) must be displayed with equal prominence.

The Audit Rule

The Audit Rule⁸ requires all RIAs to cause the private funds they advise to undergo a financial statement audit in accordance with the audit provision under the Custody Rule. Such audits must be performed by an independent public accountant and be prepared in accordance with Generally Accepted Accounting Principles (GAAP), and each such fund's audited financial statements must be delivered to the investors within 120 days after the fund's fiscal year end and promptly upon liquidation.

Though many private funds already comply with the Custody Rule's audit requirement, the Audit Rule eliminates a RIA's ability to rely on the "surprise examination" option under the Custody Rule. In recognition that a surprise examination under the Custody Rule does not satisfy this requirement, the Audit Rule includes an exception for funds and advisers not in a control relationship. With respect to an RIA that does not control and is neither controlled by nor under common control with the fund (e.g., a sub-adviser unaffiliated with the fund), the RIA need only take all reasonable steps to cause the fund to undergo an audit that meets these requirements.

The Adviser-Led Secondaries Rule

In the event an RIA initiates a transaction⁹ that offers the fund investors the option between selling all or a portion of their interests in the private fund and converting or exchanging them for new interests in another vehicle advised by the RIA or one of its related persons (an "adviser-led secondary transaction"), the RIA must 1) obtain a fairness opinion or valuation opinion from an independent opinion provider and distribute such opinion to the investors prior to the due date of any election form and 2) prepare and distribute a written summary of any material business relationships between the RIA or its related persons and the independent opinion provider within the two-year period immediately prior to the opinion issuance date.

In the Adopting Release, the SEC stated that this rule is intended to provide investors information that will enable them to make educated and informed decisions regarding their investments, particularly in adviser-led secondary transactions where there is an inherent conflict of interest. In addition, the SEC clarified that tender offers, rebalancing transactions (between parallel funds) and "season and sell" transactions would not be considered adviser-led secondary transactions because the RIA is not offering investors a choice between selling and converting or exchanging their interests in the private fund.

Rules Applicable to All Advisers

The Restricted Activities Rule

The Restricted Activities Rule¹⁰ prohibits all Advisers from engaging in certain activities unless certain disclosure and, in some cases, consent requirements are met. These prohibited activities largely address conflicts of interest between the Adviser and the private funds that it advises and compensation schemes contrary to the protection of investors.

The restricted activities subject to disclosure-based exceptions are as follows:

• Regulatory, Compliance and Examination Expenses. Advisers are prohibited from charging their private funds¹¹ for 1) regulatory or compliance fees and expenses of the Adviser or its related persons, and 2) fees and expenses associated with an examination of the Adviser or its related persons by any governmental or regulatory authority unless the Adviser delivers a written notice of any such fees or expenses, including the dollar amount thereof, to investors in the private fund at least quarterly.

Prior to the adoption of this rule, the question of whether the expenses were borne by investors in the private fund or the Adviser was left to the parties to negotiate, and many Advisers did not charge these expenses to the private funds they advised. The Proposed Rules did not provide for a disclosure-based exception and instead proposed a blanket prohibition on charging these fees to fund investors. Some commenters to the Proposed Rules pointed to the fact that allocation of fees and expenses between the Adviser and the investors is highly negotiated and proper detailed disclosure would adequately address the SEC's concern regarding transparency. The SEC found this argument persuasive and, in the Adopting Release, noted that a blanket prohibition would not be appropriate, but requiring quarterly disclosure of such fees would help ensure that investors are able to negotiate effectively and avoid compensation schemes contrary to the public interest.

• Reducing Adviser Clawbacks for Taxes. Advisers are prohibited from reducing the amount of any Adviser clawback¹² by actual, potential or hypothetical taxes applicable to the Adviser, its related persons or their respective owners or interest holders unless the Adviser distributes a written notice to the investors of the private fund that sets forth the aggregate dollar amounts of the Adviser clawback both before and after any such reduction of the clawback for actual, potential or hypothetical taxes within 45 days after the end of the fiscal quarter in which the Adviser clawback occurs.

As with the rule regarding regulatory, compliance and examination expenses discussed above, this rule was originally proposed as a complete prohibition, designed to protect investors by ensuring they receive their share of the fund profits, without reduction for tax obligations of the Adviser. As could be expected, the SEC noted in the Adopting Release that most commenters opposed this prohibition, citing, among other things, that post-tax clawbacks reflect a widely accepted and negotiated position between Advisers and investors in private funds. The SEC acknowledged the validity of the commenters' concerns and revised the final rule to include the disclosure-based exception, citing the fact that without such disclosure, many investors may lack information regarding the impact of such clawbacks on fund performance.

• Certain Non-Pro Rata Fee and Expense Allocations.¹³ Advisers are prohibited from, directly or indirectly, charging or allocating fees and expenses related to a portfolio investment (or potential portfolio investment) on a non-pro rata basis when multiple private funds and other clients advised by the Adviser or its related persons have invested (or propose to invest) in the same portfolio investment, unless 1) the non-pro rata charge or allocation is fair and equitable under the circumstances, and 2) prior to charging or allocating such fees or expenses to a private fund, the Adviser distributes to each investor of the private 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.

As with the other disclosure-based exceptions, this rule was proposed as a complete prohibition on such non-pro rata allocations. The SEC noted in the Adopting Release that this rule is aimed at addressing the inherent conflict of interest an Adviser faces in allocating such fees and expenses among private funds it advises. In light of the comments received, the SEC included a disclosure-based exception to provide Advisers flexibility while still providing the fund investors sufficient information to effectively negotiate these allocations.

Whether the non-pro rata allocation is fair and equitable will depend on the facts and circumstances. For example, the SEC noted that it would be relevant whether the expense relates to a specific security that one private fund holds or an expense related to a bespoke structuring arrangement for one private fund to participate in a portfolio investment. What will be considered fair and equitable will inevitably be fleshed out as early enforcement actions are brought. In the meantime, Advisers would likely benefit from acting conservatively and, if it will allocate fees and expenses on a non-pro rata basis, document the Adviser's rationale for such non-pro rata allocation.

The restricted activities subject to consent-based exceptions are as follows:

• Investigation Expenses.¹⁴ Advisers are prohibited from charging private funds for fees and expenses associated with an investigation of the Adviser or its related persons by any governmental or regulatory authority unless the Adviser seeks consent from all investors in such private fund and obtains written consent from at least a majority in interest of the fund's investors (excluding investors who are related persons of the Adviser).

This consent-based exception does not apply to expenses related to an investigation that results, or has resulted, in a court or government authority imposing a sanction for violation of the Advisers Act, as this would effectively be a waiver of compliance with the Advisers Act, which is prohibited under Section 215(a) of the Advisers Act. In the event such fees are charged to the fund and the investigation results in a court or governmental authority imposing a sanction on the adviser for violation of the Advisors Act, the Adviser must refund the fund for such fees and expenses associated with the investigation, including attorneys' fees.

• Borrowing.¹⁵ Advisors are prohibited from engaging in borrowing from a private fund unless the Adviser distributes a written notice and description of the material terms of the borrowing to the investors of the private fund, seeks the consent of the investors in the private fund and obtains written consent from at least a majority in interest of the fund's investors (other than investors that are related persons of the Adviser).

This rule does not specify what terms of the borrowing must be disclosed but points to the material terms related to the borrowing. Depending on the facts and circumstances, this could include the amount of the borrowing, the interest rate and the repayment schedule.

The Adopting Release clarified that though tax advances and management fee offsets have similar attributes as the prohibited borrowing arrangements, these mechanisms will not be interpreted as prohibited activities under the Private Fund Rules. With respect to tax advances, these are typically structured to be repaid through a reduction of future distributions to be received by the Adviser. However, to the extent tax advances are structured to contemplate amounts that would be repaid to the fund, it would generally be considered a borrowing restricted under the Private Fund Rules, subject to the consent requirement. With respect to management fee offsets, because they are generally structured to reduce management fees otherwise payable to the Adviser or its affiliates, this would not be considered a prohibited borrowing under this rule.

In addition, it is worth emphasizing here that for both of the restricted activities with consent-based exceptions, the request for consent must be sent to all investors in the private fund, not just a subset that represents a majority in interest. This ensures that all investors in the private fund are aware of the consent request but may be a deviation from the common practices of some Advisers when it comes to soliciting the consent of a majority in interest.

The Preferential Treatment Rule

The Preferential Treatment Rule¹⁶ prohibits all Advisers from providing certain preferential treatment to any investor in a private fund unless the Adviser satisfies certain disclosure requirements. The Preferential Treatment Rule is possibly the most impactful rule for many Advisers to private funds, especially emerging managers, as it targets the Adviser's ability to offer differing economic or information rights to certain investors on a confidential basis. The Preferential Treatment Rule prohibits the following activities:

• Redemption Rights.¹⁷ Advisers are prohibited from granting 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 the other investors in that private fund unless 1) the investor is bound by applicable laws, rules or regulations that mandate such a redemption right or 2) the Adviser has offered the same redemption ability to all existing investors and will continue to offer the same redemption ability to all future investors in the fund. Because redemption rights are generally not granted in illiquid funds, this rule will mostly impact Advisers to hedge funds.
• Information Rights.¹⁸ Advisers are prohibited from providing an investor information regarding portfolio holdings or exposures of a private fund if the Adviser reasonably expects that providing such information would have a material, negative effect on other investors in the private fund unless the Adviser offers such information to all other existing investors in the private fund at the same time or substantially the same time.

One instance in which an Adviser will give preferential information rights is with respect to strategic partners or anchor investors. These relationships will need to be reviewed by the Adviser to determine whether granting such preferential information rights will have a material, negative effect on other investors in the private fund.

What preferential information rights might cause a material, negative effect on the other investors in the private fund remains to be determined. Commenters to the Proposed Rule argued that the preferential treatment rule should apply only to open-ended funds (i.e., those with redemption rights) because it makes it more likely for preferential information to materially harm others. In particular, if investors in an open-ended fund receive preferential information rights and an ability to redeem their interests sooner than other investors, such rights may harm the remaining investors. In the Adopting Release, the SEC agreed that it is easier to trigger the material, negative effect provision in an open-ended fund and stated that the ability to redeem is an important part of determining whether providing information will have a material, negative effect on other investors. The SEC further noted that, generally, it would not view preferential information rights granted to one or more investors in an illiquid private fund as having a material, negative effect on other investors. In declining to provide a blanket exemption for all illiquid funds, the SEC stated that whether preferential information provided to an investor in an illiquid fund violates the Private Fund Rules will require a facts and circumstances analysis.

Though the SEC's comments in the Adopting Release indicate that preferential information rights without redemption rights is not likely to be considered in violation of the Private Fund Rules, this will be determined over time as we begin to see enforcement actions. As with the rule Restricted Activities Rule, Advisers would likely benefit from acting conservatively and, if any such preferential treatment is granted, documenting its analysis of any potential material, negative effects on other investors.

In addition, for all other preferential rights, the Private Fund Rules impose a disclosure obligation.¹⁹ Specifically, Advisers are prohibited from granting any other preferential treatment to investors in a private fund unless:

• advance written notice providing specific information regarding any preferential treatment related to any material economic terms is delivered to prospective investors in the private fund
• disclosure of all other preferential treatment the Adviser or its related persons has provided to an investor in the private fund is delivered to all other investors 1) with respect to liquid funds, as soon as reasonably practicable following the investor's investment in the private fund, and 2) with respect to illiquid funds, as soon as reasonably practicable following the final closing date
• annual written notice providing specific information regarding any preferential treatment the Adviser or its related persons provide to other investors in the same private fund since the last written notice

The SEC did not prescribe a particular method for delivery the foregoing disclosures, but it is expected that most Advisers will comply with this rule by delivering copies of redacted side letters or a summary compendium of the substantive provisions of all side letters or other preferential rights granted to investors in the private fund.

The Annual Review Rule

The Annual Review Rule²⁰ requires that all RIAs document the annual review of their compliance policies and procedures in writing. In the Adopting Release, the SEC noted that this requirement focuses attention on the importance of the annual compliance review process, and the new Private Fund Rules will allow SEC staff to better determine whether the RIA has complied with the annual review requirement already imposed on RIAs. It is worth noting, however, that many RIAs have likely already implemented a recordkeeping policy consistent with the new Private Fund Rules as a matter of good practice.

The Annual Review Rule does not specify the format or specific elements that RIAs must include in this written documentation. Instead, the SEC has indicated that this rule is intended to be flexible to allow RIAs to continue to use the review procedures they find most effective and suggest that the annual review may be done in a multitude of ways, including, but not limited to: 1) a lengthy written report with supporting documentation, 2) quarterly documentation that is aggregated at year end, 3) a presentation to a board or governing body, such as the limited partner advisory committee, 4) a short memorandum summarizing the findings and 5) informal documentation, such as a compilation of notes throughout the year.

The Recordkeeping Rule

Finally, the Recordkeeping Rule²¹ requires RIAs to retain books and records related to the Quarterly Statement Rule, Annual Review Rule, Adviser-Led Secondaries Rule, Preferential Treatment Rule and Restricted Activities Rule. The Recordkeeping Rule is intended to assist RIAs in identifying and remediating noncompliance efficiently and help facilitate the SEC's examination and enforcement capabilities.

Compliance Date and Legacy Status

The compliance dates²² (each, as applicable, a Compliance Date) for Advisers will vary for the different provisions of the Private Fund Rules and the size of the Adviser. All RIAs will be required to comply with the Audit Rule and Quarterly Statement Rule by the date that is 18 months after the date of publication of the Private Fund Rules in the Federal Register (Publication Date). Advisers with $1.5 billion or more in private fund assets under management (Large Advisers) will need to be in compliance with the Adviser-Led Secondaries Rule (applicable to RIAs only), Preferential Treatment Rule and Restricted Activities Rule by the date that is 12 months after the Publication Date. Advisers with less than $1.5 billion in private funds assets under management (Small Advisers) will need to be in compliance with the Adviser-Led Secondaries Rule (applicable to RIAs only), Preferential Treatment Rule and Restricted Activities Rule by the date that is 18 months after the Publication Date. Finally, compliance with the Annual Review Rule applicable to RIAs will be required 60 days after the Publication Date.

For ease of reference, the Compliance Dates are provided below. All dates are calculated from the Publication Date:

The Private Fund Rules grant legacy status to certain aspects of the Preferential Treatment Rule (preferential redemption and information rights) and the Restricted Activities Rule (borrowing and charging fees for certain investigations) in the event the Private Fund Rules. Legacy status means that Advisers to existing private funds will not be subject to these aspects of the Private Fund Rules with respect to those private funds in existence prior to the applicable Compliance Date if the Private Fund Rules would otherwise require an amendment to existing governing documents.²³ The SEC clarified, however, that the legacy status will be available only to agreements with respect to private funds that have commenced operations as of the applicable Compliance Date (i.e., commenced bona fide activity toward operating a private fund, including investment, fundraising or operational activity). Examples of such bona fide activity include issuing capital calls, setting up a subscription facility for the fund, holding an initial closing, conducting due diligence on potential fund investments or making an investment on behalf of the fund.²⁴

Importantly, the disclosure portions of the Preferential Treatment Rule and Restricted Activities Rule did not receive legacy status. With respect to the Preferential Treatment Rule, this means that information inside letters existing prior to the Compliance Date would need to be disclosed 1) to prospective investors investing in the fund after the Compliance Date and 2) to all investors a) with respect to liquid funds, as soon as reasonably practicable following the new investor's investment in the private fund and b) with respect to illiquid funds, as soon as reasonably practicable following the final closing date. While the language in the Adopting Release is unclear, it appears that Advisers to illiquid private funds that have a final closing date prior to the applicable Compliance Date will need to disclose to all investors upon the Compliance Date any preferential treatment granted to investors in such private fund.²⁵

Conclusion

As noted above, the final Private Fund Rules contain significant modifications from the Proposed Rules and are far less restrictive than originally proposed. However, the new rules and restrictions will likely affect every Adviser in meaningful ways. While the Compliance Dates are relatively far off, Advisers should begin to understand how the Private Fund Rules will affect their fundraising and operations once effective, including how the rules with legacy status will apply to such Advisers. In addition, though certain aspects of the rule that require a facts and circumstances analysis will become clearer as the rule is interpreted through no-action letters and enforcement actions, the Adopting Release has helpful commentary on how the SEC will likely interpret those aspects of the Private Fund Rules and be a guiding light in the meantime.

Notes

¹ Pursuant to the Adopting Release, the SEC adopted the following: 17 CFR 275.206(4)-10 (final rule 206(4)-10), 17 CFR 275.211(h)(1)-1 (final rule 3 211(h)(1)-1), 17 CFR 275.211(h)(1)-2 (final rule 211(h)(1)-2), 17 CFR 275.211(h)(2)-1 (final rule 211(h)(2)-1), 17 CFR 275.211(h)(2)-2 (final rule 211(h)(2)-2) and 17 CFR 275.211(h)(2)-3 (final rule 211(h)(2)-3) under the Advisers Act.

² Section 202(a)(29) of the Advisers Act defines the term "private fund" as an issuer that would be an investment company, as defined in Section 3 of the Investment Company Act of 1940 (15 U.S.C. 80a-3) (Investment Company Act), but for Section 3(c)(1) or 3(c)(7) of the Investment Company Act.

³ "SEC Enhances the Regulation of Private Fund Advisers," SEC 2023-155 (Aug. 23, 2023).

⁴ References to RIAs include private fund advisers required to be registered with the SEC.

⁵ An ERA is an investment adviser who qualifies for the exemption from registration under rule 203(l)-1 or rule 203(m)-1 under the Advisers Act.

⁶ 17 C.F.R. 275.206-2.

⁷ Final rule 211(h)(1)-2; SEC Release No. IA-6383 at 60.

⁸ Final rule 206(4)-10; SEC Release No. IA-6383 at 161.

⁹ Final rule 211(h)(2)-2; SEC Release No. IA-6383 at 186.

¹⁰ Final rule 211(h)(2)-1; SEC Release No. IA-6383 at 205.

¹¹ Page 23 SEC Release No. IA-6383 at 212.

¹² Page 23 SEC Release No. IA-6383 at 218.

¹³ SEC Release No. IA-6383 at 224.

¹⁴ SEC Release No. IA-6383 at 236.

¹⁵ SEC Release No. IA-6383 at 243.

¹⁶ Final rule 211(h)(2)-3; SEC Release No. IA-6383 at 261.

¹⁷ SEC Release No. IA-6383 at 274.

¹⁸ SEC Release No. IA-6383 at 280.

¹⁹ SEC Release No. IA-6383 at 290.

²⁰ Final amended rule 206(4)-7(b); SEC Release No. IA-6383 at 302.

²¹ Final amended rules 204-2(a)(20) through (23); SEC Release No. IA-6383 at 547.

²² SEC Release No. IA-6383 at 308.

²³ SEC Release No. IA-6383 at 315.

²⁴ Id.

²⁵ SEC Release No. IA-6383 at 313.