Earlier this summer, we wrote about both new and amended rules proposed by the Securities and Exchange Commission (“SEC”) under the Investment Advisers Act of 1940 (the “Advisers Act”) regarding private funds, their advisers, and transparency to investors (the “Proposed Rules”). On August 23, 2023, the SEC adopted the final rule (the “Rule”), which cut back certain aspects of the Proposed Rules while still expanding the regulatory environment for private fund advisers and investors. A brief overview of the Rule is as follows:
Reporting Requirements for Registered Advisers
The below rules contain requirements (and as applicable, prohibitions) for advisers that are registered with the SEC:
- Quarterly Statement Rule: Advisers must distribute a quarterly statement to fund investors, which must disclose information in respect of fund performance (the nature of which varies depending on the liquidity of the fund), the cost of investing in the fund, expenses and fees disbursed by the fund and the manner in which expenses, payments, allocations, rebates, waivers, and offsets are calculated, and an account of certain payments and other compensation paid to the adviser or its related persons, as well as any compensation paid or allocated by the fund’s portfolio investments.
- Audit Rule: Advisers must cause the funds they advise to have a yearly financial statement audit. The audit must satisfy the requirements of the audit provisions of the custody rule under the Advisers Act. The intent behind the audit is to ensure the adviser’s valuation of the fund’s assets is accurate and to protect investors from any bad acts or misappropriation of the adviser.
- Adviser-Led Secondaries Rule: Advisers must obtain a fairness or valuation opinion when offering existing investors the option between (i) selling such investor’s interest in the fund and (ii) exchanging their interests for those of another fund vehicle advised by the adviser or any of its related persons. Advisers must also produce and issue to the investors an overview of any substantive business relationships the adviser has (or has had within the previous two years) with the person providing such independent opinion.
- Books and Records: The above reforms also include amendments to the books and records rule under the Advisers Act to ensure compliance with the Rule and enable the SEC to access such compliance in a fulsome manner. Moreover, advisers must document in writing an annual review of their compliance policies and procedures, which includes capturing the adequacy of such policies and procedures and their effectiveness.
Prohibited Activities for All Advisers
The below rules contain requirements (and as applicable, prohibitions) for all advisers whether such advisers are registered with the SEC or exempt from registration.
- Restricted Activities Rule: Advisers will be restricted from engaging in certain activities to better protect investors, which includes: (i) charging fees or expenses related to an investigation of the adviser without disclosing to fund investors and receiving their consent; (ii) charging fees or expenses related to regulatory, examination, or compliance of the adviser, unless disclosed to investors; (iii) reducing the amount of an adviser clawback by certain taxes, unless the pre- and post-tax amount of such clawback is disclosed to investors; (iv) charging or allocating fees or expenses related to an investment on a non-pro rata basis unless it is fair and equitable and investors receive advance written notice from the adviser with a description as to why it is fair and equitable; and (v) receiving a line of credit from a fund client without disclosure to and consent from the investors.
- Preferential Treatment Rule: Advisers are prohibited from providing preferential treatment to investors in respect of: (i) certain redemptions, unless required by applicable law or redemption is offered to all investors that don’t qualify, and (ii) providing information about fund holdings unless the information is offered to all investors. More generally, advisers cannot provide investors preferential treatment unless prospective investors, before making their investment, are provided written notice with specific information about any preferential treatment being provided to other investors.
- Legacy: The SEC is providing legacy status, which will apply to governing documents and agreements that were entered into prior to the compliance date if the applicable rule would require amendments to such documents and agreements, particularly in respect of (i) the prohibition under the Preferential Treatment Rule of advisers from providing certain preferential redemption rights and information about portfolio holdings, and (ii) aspects of the Restricted Activities Rule that require investor consent. Notwithstanding the foregoing, this legacy status excludes charging for fees or expenses related to an investigation that results or has resulted in a court or governmental authority imposing a sanction for a violation of the Advisers Act.
Effectiveness, Timing of Compliance
The effective date of the Rule will be 60 days after its publication in the Federal Register. Compliance with sub-rules of the Rule, however, will vary. For the Audit Rule and the Quarterly Statement Rule, the SEC is adopting an 18-month transition period for all private fund advisers to which they apply. For the Adviser-Led Secondaries Rule, the Preferential Treatment Rule, and the Restricted Activities Rule, the SEC is adopting compliance dates that provide for transition periods as follows: (i) for advisers with $1.5 billion or more in private funds assets under management, a 12-month transition period, and (ii) for advisers with less than $1.5 billion or more in private funds assets under management, an 18-month transition period. Lastly, compliance with the amended compliance requirements will be required 60 days after the Rule is published in the Federal Register.
The Rule is aimed at leveling the playing field among investors while also increasing transparency for investors as to advisers and a fund’s operations. While these are good-natured goals, there are some drawbacks, notably the increased cost for funds and their advisers in complying with the Rule. While some funds and advisers are already contractually obligated to provide some of the above information, the various disclosures, reporting, and compliance requirements take time and money to produce and comply with, and may be an added burden on funds and their advisers. Moreover, prior to the Rule being final, at least one organization (which includes many of the biggest hedge fund and private equity firms in the world) told its members it may sue the SEC depending on how the Rule compared to the Proposed Rules. While, as noted above, the Rule does scale back from the Proposed Rules, it’s unclear whether litigation may be on the horizon for the SEC.
For now, funds, advisers, investors, and related organizations — to the extent not already aware — should fully digest the new rule and consult with their attorneys and advisers to get a better sense of what compliance — when it becomes mandatory — will look like and how to plan accordingly.