SEC Proposes Significant Changes to Regulation of Private Fund Advisers
The U.S. Securities and Exchange Commission (“SEC”) recently voted in favor of proposed new rules (the “Proposed Rules”) which significantly expand the regulation of private fund advisers under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), and apply in certain respects not only to SEC-registered private fund advisers (“RIAs”) but also to unregistered private fund advisers. The full text of the Proposed Rules is available at https://www.sec.gov/rules/proposed/2022/ia-5955.pdf. Below is a brief discussion of the Proposed Rules and certain other proposed amendments under the Advisers Act.
1. Quarterly Disclosure Statements to Investors
The Proposed Rules require an SEC-registered private fund adviser prepare a quarterly statement with comprehensive disclosure regarding the fees, expenses and performance for any private fund that the RIA advises, and to distribute the quarterly statement to the private fund’s investors within 45 days after each calendar quarter end, unless such quarterly statement is prepared and distributed by another party.
The proposed quarterly statement would lay out, in a table format: (i) all compensation, fees and other amounts allocated or paid to the private fund adviser or any of its related persons by the private fund during the reporting period; (ii) all fees and expenses paid by the private fund during the reporting period other than those listed in item (i); and (iii) the amount of any offsets, rebates or waivers carried forward during the reporting period to subsequent quarterly periods to reduce future payments or allocations by the private fund to the private fund adviser or its related persons.
The quarterly disclosure statement must also provide standardized fund performance information, with different performance metrics for liquid funds (performance based on net total return) versus illiquid funds (performance based on internal rate of return).
2. Mandatory Private Fund Audits
The Proposed Rules require SEC-registered private fund advisers to obtain an annual audit of the financial statements of the private funds they manage.
The annual audit of the private funds must meet various requirements (many of which are similar or identical to the audit provisions of the Custody Rule of the Advisers Act), including:
- the audit must be performed by an independent public accountant registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board;
- the audit must meet the definition of “audit” of Rule 1-02(d) of Regulation S-X;
- the financial statements must be prepared in accordance with U.S. GAAP or, if the fund or its general partner or manager is organized outside of the United States, the financial statements must contain information substantially similar to statements prepared in accordance with U.S GAAP and any material differences must be reconciled;
- the audited financial statements must be distributed to the investors promptly after the audit is completed; and
- the auditor must notify the SEC in the event the auditor issues a modified opinion to the fund or resigns or is dismissed from performing the fund audits.
For a private fund that the private fund adviser advises but does not control (e.g., a sub-advised fund), the private fund adviser must take all reasonable steps to cause the private fund to undergo an annual audit meeting the above requirements.
3. Adviser-Led Secondaries Fairness Opinions
The Proposed Rules require that a private fund adviser obtain a fairness opinion in connection with certain adviser-led secondary transactions (e.g., when an adviser offers private fund investors the option to sell their interests in the private fund, or to exchange their interests for new interests in another private fund managed by the private fund adviser). The fairness opinion must be obtained prior to the close of a transaction and must be issued by an independent party.
4. Certain Prohibited Activities
The Proposed Rules prohibit a private fund adviser from engaging in certain activities that the SEC believes are “contrary to the public interest and protection of investors” including, among others, those set forth below.
- Fees and Expenses. Charging to a private fund: (i) fees and expenses incurred in connection with an examination or investigation of the private fund adviser by governmental or regulatory authorities; (ii) accelerated monitoring fees; (iii) adviser-level regulatory or compliance expenses; or (iv) non-pro rata fees and expenses related to portfolio investments in which multiple clients have an interest.
- Clawback. Reducing the amount of the private fund adviser’s clawback by any actual or potential tax liability of the private fund adviser or its related persons.
- Indemnification and Exculpation. Seeking reimbursement, indemnification, exculpation or limitation of the liability of the private fund adviser in connection with a breach of fiduciary duty, willful malfeasance, bad faith, recklessness or negligence on the part of the private fund adviser.
- Borrowing From Private Fund Clients. Borrowing money, securities or other fund assets, or receiving a loan or line of credit, from a private fund. The Proposed Rule does not prohibit the private fund adviser from lending to a private fund, including for subscription lines.
The foregoing prohibitions apply to all private fund advisers, regardless of whether the advisers are registered with, or reporting as exempt reporting advisers to, the SEC or one or more state securities commissioners or are otherwise not required to register. The Proposed Rules currently do not include any “grandfathering” provisions for private fund advisers thereby likely necessitating a review and revision to the private funds’ governing documents.
5. Preferential Treatment of Investors Prohibitions and Disclosures
The Proposed Rules prohibit all private fund advisers (regardless of registration status) from granting certain preferential terms to select private fund investors and, furthermore, require that private fund advisers disclose preferential terms to current and prospective investors in the private fund.
Prohibitions. The Proposed Rules prohibit a private fund adviser from entering into arrangements (e.g., side letters) with select private fund investors that (i) grant preferential liquidity rights or redemption terms in the private fund or a substantially similar pool of assets managed by the private fund adviser (together, the “Vehicles”) or (ii) provide enhanced information regarding portfolio holdings or portfolio exposures of the private fund or other Vehicle, in each case if the private fund adviser reasonably believes such preferential treatment would have a “material, negative effect” on other investors in the private fund or other Vehicle.
Disclosures. The private fund adviser must provide written disclosure of all preferential terms to (i) prospective investors prior to their investment in the private fund and (ii) current investors in the private fund on an annual basis. The disclosure must provide sufficient detail regarding a preferential term to convey its relevance (e.g., lower fees granted to an investor in exchange for a larger contribution). The SEC suggests such disclosure requirement can be satisfied by providing prospective and current investors with redacted side letters, or with written, specific summaries of all preferential terms.
Amendments to Books and Records Rule and Compliance Policies Rule
In addition to the Proposed Rules, the SEC proposed (i) corresponding amendments to Rule 204-2 of the Advisers Act to require that RIAs maintain any and all books and records created in connection with the new disclosure requirements and (ii) amendments to Rule 206(4)-7 of the Advisers Act to require that all RIAs document in writing the annual review of their compliance policies and procedures.
The Proposed Rules are open for public comment until the later of (i) the expiration of the 30-day period running from publication in the Federal Register (which has yet to occur) and (ii) April 11, 2022. Given the expansive nature of the Proposed Rules, the comment period is relatively short.
Following the adoption of the Proposed Rules in their final form, the SEC proposes that the rulemaking have an effective date 60 days following the publication of the final rules in the Federal Register, and a compliance date that falls one year thereafter.
If adopted in their current form, the Proposed Rules would significantly alter and expand the compliance obligations for both SEC-registered private fund advisers and unregistered private fund advisers. The Proposed Rules will likely result in increased compliance costs for both private fund advisers and the private funds themselves.
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