SEC Adopts Final Rules on Private Fund Advisers; Documentation of Registered Investment Adviser Compliance

On August 23, 2023, the Securities and Exchange Commission (“Commission” or “SEC”) adopted extensive new Rules¹ under the Investment Advisers Act of 1940 (“Advisers Act” or “Act”) increasing the regulation of investment advisers, with a focus on private fund investment advisers.

Specifically, the Commission promulgated five new Rules under the Advisers Act and made amendments to two existing Rules (collectively, the “Rules”).  The Rules were originally proposed in February 2022,² receiving substantial industry comments in the rulemaking process.  As revised, the Rules address the following:

1. Quarterly Statement Rule. SEC-registered private fund advisers will be required to distribute quarterly statements to private fund³ investors, which must include certain fund-level performance information, disclosures on the cost of investing in the private fund, fees and expenses paid by the private fund and compensation paid to the adviser from underlying investments.  There are several important and potentially complicated components of the required quarterly reports, such as describing the impact of subscription line financing on fund performance.
 
Such quarterly statements must be distributed (i) for a private fund that is not a fund‑of‑funds, within 45 days after the end of each of the first three fiscal quarters and 90 days after the end of each fiscal year, and (ii) for a private fund that is a fund‑of‑funds, within 75 days after the end of each of the first three fiscal quarters and 120 days after the end of each fiscal year.

2. Private Fund Audit Rule. SEC-registered private fund advisers must cause each of the private funds they advise to undergo a financial statement audit that meets the requirements of the audit provision in the Advisers Act Custody Rule.  Such audited financial statements must be delivered to investors in the private fund within 120 days of the private fund’s fiscal year-end and promptly upon liquidation.  Many private funds are already complying with this requirement as part of their compliance with the Custody Rule. 

3. Adviser-Led Secondaries Rule. SEC-registered private fund advisers must obtain a fairness opinion or valuation opinion from an independent opinion provider.  In addition, SEC-registered private fund advisers must prepare and distribute to the private fund’s investors, a summary of any material business relationships the adviser has, or has had within the prior two years, with the independent opinion provider.

4. Restricted Activities Rule. All private fund advisers (including those that are not registered with the SEC), will be restricted from engaging in the following activities:

• Charging or allocating to the private fund, fees or expenses associated with an investigation of the adviser without disclosure and consent from the fund investors. In addition, an adviser may not (regardless of disclosure) charge fees or expenses related to an investigation that results, or has resulted, in a court or governmental authority imposing a sanction on the adviser for a violation of the Advisers Act or the Rules promulgated thereunder.
• Charging or allocating to the private fund, regulatory, examination, or compliance fees or expenses of the adviser, unless such fees and expenses are disclosed to investors.
• Reducing the amount of an adviser clawback by the amount of certain taxes, unless the adviser discloses the pre-tax and post-tax amount of the clawback to investors.
• Charging or allocating fees or expenses related to a portfolio investment on a non-pro rata basis, unless the allocation approach is fair and equitable, and the adviser distributes advance written notice of the non-pro rata charge along with a description of how the allocation approach is fair and equitable under the circumstances; and
• Borrowing or receiving an extension of credit from a private fund client without disclosure to, and consent from, fund investors.

5. Preferential Treatment Rule. All private fund advisers (regardless of whether they are registered with the SEC) are prohibited from providing preferential treatment (through side letters or otherwise) to investors with respect to (i) redemption rights and information transparency if, in each case, the adviser reasonably expects such preferential treatment to have a material, negative effect on other investors, subject to certain exceptions outlined below, and (ii) other types of preferential treatment to any investor in a private fund, unless the adviser satisfies certain disclosure obligations.

Preferential Treatment Generally – Disclosure

Except with respect to (i) redemption rights, and (ii) information transparency (discussed below), all private fund advisers are prohibited from, directly or indirectly, providing preferential terms to any investor in a private fund unless such adviser has provided each prospective investor in the private fund, prior to the investor’s investment in the private fund, a written notice that provides specific information regarding any preferential treatment related to any material economic terms that the adviser or its related persons provide to other investors in the same private fund.

Additionally, at the end of the fundraising period for an illiquid fund, a private fund adviser must provide all investors with notice of all preferential terms.  For liquid funds, the private fund adviser must give notice as soon as reasonably practicable following the investment by the investor receiving the preferential terms.  On an annual basis, the private fund adviser must also provide written notice that details specific information regarding any preferential treatment provided by the adviser, or its related persons, to other investors in the same private fund since the last written notice provided in accordance with this section, if any.

Preferential Redemption Rights – Prohibition

All private fund advisers (regardless of whether they are registered with the SEC) are prohibited from, directly or indirectly, providing preferential terms for redemptions that the adviser reasonably expects to have a material negative effect on other investors, except where (i) the ability to redeem is required by applicable law or (ii) the adviser offers the preferential redemption right to all other investors without qualification.  

Preferential Portfolio Information Rights – Prohibition

All private fund advisers (regardless of whether they are registered with the SEC) are prohibited from providing information regarding portfolio holdings or exposures of a private fund to an investor if the adviser reasonably expects that providing such information would have a material, negative effect on other investors in that private fund, except if the adviser offers such information to all other existing investors at the same time or substantially at the same time.

6. Books & Records Amendment. Corresponding amendments to the Advisers Act’s books and records rule have been enacted to facilitate the Commission’s ability to assess an adviser’s compliance with the Rules.

7. Compliance Rule Amendment. Amendments were also adopted to the Compliance Rule, which requires all SEC-registered advisers (including those that do not advise private funds) to document in writing the required annual review of their compliance policies and procedures.  The Commission notes that such written documentation will help the Commission determine Advisers Act compliance with the Rules and identify potential weaknesses.

Advisers Subject to the Rules

The scope of the advisers subject to the Rules is unchanged from the proposal, with the exception that advisers to securitized asset funds (funds whose primary purpose is to issue asset-backed securities such as CLOs) are not subject to any of the Rules.  

• The Quarterly Statement Rule, the Private Fund Audit Rule and the Adviser-Led Secondaries Rule apply to all SEC-registered advisers.
• The Restricted Activities Rule and Preferential Treatment Rule apply to all advisers to private funds (regardless of registration).
• The Compliance Rule amendment applies to all SEC-registered advisers (even if they do not advise private funds).

In the adopting release, the SEC clarified that the Rules do not apply to offshore advisers with respect to offshore funds (even those offshore funds with onshore investors).

Legacy Status to Certain Aspects of the Rules

In response to comments, the Commission agreed to provide legacy status (i.e., grandfathering) for certain aspects of (i) the Preferential Treatment Rule (specifically, the prohibition on providing certain preferential redemption and information about portfolio holdings), and (ii) the Restricted Activities Rule (specifically, the restriction on charging certain investigation fees and expenses without disclosure and consent from the private fund investors).  

The legacy status provisions apply to any governing agreements (including limited partnership agreements, investor side letters as well as credit agreements and borrowing arrangements) that were entered into prior to the compliance date if the applicable Rule would require the parties to amend the agreements.  

The Commission has not provided legacy status for disclosure portions of the Preferential Treatment Rule. As a result, information in side letters that existed before the compliance date is now required to be disclosed to investors that invest in a private fund post the compliance date. 

The Commission also did not apply legacy status to the aspects of the Restricted Activities Rule with disclosure-based exceptions.  The Commission’s justification in not granting legacy treatment to those disclosure-based aspects is that disclosure of information under the Preferential Treatment Rule and Restrictive Activities Rule is not burdensome and disruptive (when compared to the prohibitions which would require the repapering of existing contracts).

Compliance Dates

• For the Private Fund Audit Rule and the Quarterly Statement Rule, the compliance date will be 18 months after the date of publication of the final Rules in the Federal Register.
• For the Adviser-Led Secondaries Rule, the Preferential Treatment Rule and the Restricted Activities Rule, the compliance dates are phased based upon the size of the adviser:
  • for larger private fund advisers (advisers with $1.5 billion or more in private funds assets under management), 12 months after the date of publication; and
  • for smaller private fund advisers (advisers with less than $1.5 billion in private funds assets under management), 18 months after the date of publication.
• For the amended Compliance Rule, the compliance date will be 60 days after publication.

Key Takeaways

While the final Rules do include more flexibility with exceptions for preferential terms and restricted activities and exclude some of the contentious provisions of the February 2022 proposed rules, the final Rules will still impose significant new requirements on private fund advisers and expand the SEC’s oversight on the industry.

According to the Commission, the final Rules seek to protect investors who directly or indirectly invest in private funds by increasing visibility into certain practices involving compensation schemes, sales practices and conflicts of interest through disclosure.  The SEC aims to (i) establish these requirements to address such practices that have the potential, in the Commission’s view, to lead to investor harm, and (ii) restrict practices that the Commission believes to be contrary to the public interest in an effort to provide protection to the investors.

The final Rules were adopted by a 3 to 2 vote (Commissioners Gensler, Crenshaw and Lizarraga voted for and Commissioners Peirce and Uyeda voted against).  The Commission’s open meeting discussing and enacting the Rules featured an unusually lively debate among the commissioners around the propriety of the new Rules and the authority of the Commission to adopt them.  It is rare for the SEC staff or the commissioners to address legal authority or administrative process questions at an open meeting when new Rules are under consideration, and it suggests the agency takes the threat of litigation to challenge the new Rules seriously.  Nevertheless, absent an injunction or other voluntary stay of the Rules, market participants should continue preparing for compliance with the Rules in advance of the relevant effective dates.

¹ Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, Release No. IA6383 (Aug. 23, 2023) (Adopting Release).

² Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, Release No. IA5955 (Feb. 9, 2022).

³ The Adopting Release defines “Private Fund” as a privately offered investment vehicle that pools capital from one or more investors and invests in securities and other instruments or investments, but then includes a footnote that 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 that Act.  The footnote further clarifies that the Adopting Release uses the term “private fund” and “fund” interchangeably.