On August 23, 2023, the U.S. Securities and Exchange Commission (SEC) adopted new rules and amendments to the Investment Advisers Act of 1940 (Advisers Act). These changes represent a significant step in enhancing the regulation of private fund advisers. In this article, we will provide an overview of the key requirements and restrictions outlined in these reforms and their implications for the private fund industry.
Here’s what the reforms require for Registered Private Fund Advisers:
I. The Preferential Treatment Rule
The Preferential Treatment Rule, centered on Disclosure Requirements, signifies a pivotal transformation in the landscape of private fund investments. This rule places stringent demands on advisers, mandating them to adhere to transparent disclosure practices before admitting investors into a fund. Key facets of this rule encompass:
Advance Disclosure: Prior to admitting an investor, advisers are obligated to provide advanced disclosure of material economic terms that have been preferentially granted to other investors.
Continuous Transparency: Furthermore, advisers are tasked with promptly disclosing any additional instances of preferential treatment “as soon as reasonably practicable” after the conclusion of the fundraising period (for illiquid funds) or the investor’s investment (for liquid funds). Subsequently, this disclosure must occur at least annually concerning any new preferential terms.
Game Changer: Transforming the Fund’s Landscape
The Preferential Treatment Rule brings about a significant shift in the traditional dynamics of fund investments, notably impacting the “most favored nation” (MFN) process. It mandates proactive disclosure of material economic terms, even to investors who traditionally wouldn’t have access to such information. For instance, smaller investors without side letters will now receive this critical information.
Crucially, this rule applies retrospectively to existing funds, meaning older funds must also adhere to the disclosure requirements, reinforcing the SEC’s commitment to transparency and accountability.
Compliance Timelines and Grandfathering
Compliance with the Preferential Treatment Rule is governed by distinct timelines based on advisers’ size. Larger advisers are obliged to comply within 12 months, while smaller advisers are granted an 18-month compliance window.
Importantly, the Preferential Treatment Rule does not offer provisions for grandfathering existing funds. Consequently, all private funds, regardless of their inception date, must adhere to the disclosure standards outlined in this rule. This underscores the SEC’s dedication to promoting transparency and safeguarding investor interests.
Moreover, an adviser is prohibited from extending preferential treatment to investors with redemption terms that could significantly harm other investors, unless such terms are legally mandated or equally accessible to all fund investors without conditions. Similarly, an adviser cannot selectively disclose preferential information about portfolio holdings or exposures if doing so would adversely impact other investors, unless this information is made available to all investors on an equitable basis.
II. The Quarterly Statement Rule
Under the Final Rules, registered investment advisers must provide comprehensive quarterly statements for private funds they advise. These statements must include detailed information on fund-level performance, the expenses associated with investing in the fund (broken down into itemized fees and expenses), any offsets or fee waivers, and a detailed account of payments made to the adviser or its related individuals by each portfolio company.
The rule imposes a significant burden by requiring the disclosure of performance metrics for illiquid funds, both with and without the influence of fund-level subscription facilities. Additionally, it necessitates a clear breakdown of all fund-level and portfolio company-level special fees and expenses, such as monitoring fees, with cross-references to the private fund’s organizational and offering documents outlining the calculation methods. This level of detail could potentially trigger reviews by the SEC staff of performance calculations and fee and expense allocations during examinations. The timing deadlines for quarterly and year-end statements are also expected to pose operational challenges for sponsors.
Key points of the rule include:
Compliance Date: The rule becomes effective 18 months after its implementation for both larger and smaller advisers.
Existing Funds: Existing funds are not grandfathered. Registered advisers must prepare quarterly statements that disclose fees, expenses, and performance for each private fund they advise. These statements must include disclosures on how expenses, payments, allocations, rebates, waivers, and offsets are calculated and should reference the private fund’s organizational and offering documents for calculation methods. Criteria and assumptions used in calculating performance must also be disclosed, and copies of quarterly statements, along with related records, must be retained.
Contents of Quarterly Statements: Quarterly statements must contain:
A detailed account of all compensation, fees, and other amounts allocated or paid to the adviser during the reporting period.
A comprehensive breakdown of fees and expenses allocated or paid for fund-related expenses, including organizational fees, accounting, legal, administrative fees, audit, tax, due diligence, and travel during the reporting period.
An itemized account of the amount of offsets or rebates carried forward during the reporting period to reduce future payments or allocations to the adviser.
A statement of contributions and distributions for an illiquid fund.
Performance Disclosure:
For liquid private funds, performance must be disclosed based on net total return annually, over specified time periods, and quarterly for the current year.
For illiquid private funds, performance must be disclosed based on the internal rate of return and a multiple of invested capital, both on a net and gross basis, with a separate presentation for realized and unrealized portions of the portfolio.
Timing of Quarterly Statements
Most private funds’ quarterly statements must be prepared and distributed within 45 days after the first three fiscal quarter ends of the fiscal year and 90 days after the fiscal year’s end.
Quarterly statements for private funds of funds must be prepared and distributed within 75 days after the first three fiscal quarter ends of each year and 120 days after the fiscal year’s end.
New private funds must begin preparing and distributing quarterly statements after two full calendar quarters of operation and continue to do so each quarter thereafter.
III. The Restricted Activities Rule
This Rule is applicable to all advisers of private funds, introduces a series of limitations on certain practices within the industry. These restrictions encompass various activities, including charging investigation fees, regulatory or compliance fees, adviser clawbacks, fees related to portfolio investments, and borrowing from clients of private funds. Under these rules, advisers of private funds are constrained in several ways.
Advisers cannot charge or allocate investigation fees for governmental or regulatory investigations without obtaining consent from a majority of disinterested investors. Furthermore, such fees cannot be charged if sanctions are imposed for violations. This rule, while designed to enhance transparency, places an added burden on sponsors who can no longer allocate investigation costs to a fund without securing investor consent.
The rule governs regulatory and compliance costs. Advisers cannot charge these expenses to a private fund without distributing a written notice, with dollar amounts, within 45 days after the end of the fiscal quarter in which the charges occur. Additionally, the SEC discourages advisers from allocating certain “manager-level” expenses to the fund. This aspect of the rule might affect the prevailing practice of distributing regulatory costs to the fund.
The after-tax clawback rule stipulates that advisers cannot reduce the GP clawback by taxes unless they disclose both pre-tax and post-tax clawback amounts within 45 days of the fiscal quarter’s end in which the clawback takes place. Advisers using hypothetical taxes must provide notice and specific dollar amounts.
Advisers are prohibited from charging fees or expenses related to a portfolio investment on a non-pro rata basis unless they can justify it as “fair and equitable” and provide advance notice. This rule may compel advisers to reconsider how they allocate certain costs.
The rule addresses borrowing from the fund. Advisers are not allowed to borrow or receive credit from a private fund without disclosing it to and obtaining consent from fund investors. Notably, this rule does not pertain to sponsors lending money to the fund.
These rules are introduced to bolster transparency and safeguard investor interests, yet they may present operational challenges and influence cost allocation practices among advisers of private funds.
IV. The Private Fund Audit Rule
This rule mandates that registered advisers must secure an annual audit for each private fund, provided the fund meets the specified audit provision requirements in the Advisers Act custody rule (Rule 206(4)-2). Notably, the option to opt-out of this audit requirement using surprise examinations is no longer available. While many private fund sponsors already comply with the custody rule by providing audited financial statements, those who previously relied on surprise examinations will be directly affected by this change.
The compliance date for both Larger and Smaller Advisers to adhere to the Private Fund Audit Rule is set at 18 months. Importantly, there is no provision for grandfathering existing funds; all private funds must now comply with the new audit requirement.
Under the New Rule pertaining to audits, registered advisers of private funds must secure annual audits of financial statements. These audits are subject to specific requirements, including being conducted by an independent public accountant meeting defined independence standards and registered with the Public Company Accounting Oversight Board (PCAOB). The audited financial statements should adhere to generally accepted accounting principles and must be delivered to investors within 120 days after the private fund’s fiscal year-end and promptly upon liquidation.
Moreover, the Books and Records Rule Amendments highlight the necessity of maintaining precise records that demonstrate compliance with the new rules. It’s expected that the SEC staff will focus on this requirement during routine examinations.
The compliance date for the Books and Records Rule Amendments is tied to the underlying rule for which records are required. Similar to the Private Fund Audit Rule, there is no provision for existing funds to be grandfathered; compliance with these new rules is mandatory for all private funds.
V. The Adviser Led Secondary Transactions Rule
This Rule applies to registered private fund advisers and introduces specific mandates for transactions initiated by these advisers, giving private fund investors the choice to either sell a portion of their interests in the private fund or exchange them for interests in another vehicle managed by the adviser. This rule imposes two key requirements:
Registered private fund advisers must obtain and provide a fairness opinion or valuation opinion from an independent opinion provider as an integral part of adviser-led secondary transactions. This opinion serves to ensure transparency and fairness in such transactions.
Advisers are obligated to distribute a written summary disclosing any significant business relationships they have had, or currently maintain, within the two years leading up to the issuance of the fairness or valuation opinion, particularly focusing on relationships with the independent opinion provider. This disclosure aims to provide investors with a comprehensive understanding of potential conflicts of interest.
The compliance timeline for these new rules depends on the assets under management by the adviser:
Advisers overseeing less than $1.5 billion in assets have an 18-month window to comply from the date of publication in the Federal Register.
Advisers with assets equal to or greater than $1.5 billion have a 12-month compliance period from the date of publication.
A Significant Transformation for Private Fund Advisors
The recent regulatory changes adopted by the U.S. Securities and Exchange Commission (SEC) in August 2023 present a significant transformation for private fund advisers. These reforms, summarized in this article, introduce a heightened level of transparency and compliance requirements for registered private fund advisers.
The Preferential Treatment Rule revolutionizes private fund investments by mandating advanced disclosure and continuous transparency, affecting the “most favored nation” (MFN) process, and extending transparency to all investors.
The Quarterly Statement Rule requires comprehensive quarterly reporting, including performance metrics, fees, expenses, and detailed accounting, while posing operational challenges and emphasizing meticulous record-keeping.
The Restricted Activities Rule places constraints on various practices, aiming to enhance transparency but potentially influencing cost
allocation practices.
The Private Fund Audit Rule mandates annual audits for private funds, with stringent compliance timelines and no provision for existing funds to be exempt, underscoring the SEC’s auditing commitment.
The Adviser Led Secondary Transactions Rule introduces fairness and transparency requirements for such transactions, addressing conflicts of interest and safeguarding investor interests.
Compliance varies depending on fund types and size, making it crucial for businesses to understand how these new rules may impact their operations within the private fund industry, ensuring full compliance with these reforms that enhance transparency, protect investors, and address conflicts of interest.
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