Overview

On August 23, 2023, the Securities and Exchange Commission (the “SEC”) issued sweeping final rules and amendments to the Investment Advisers Act of 1940, as amended (the “Advisers Act”) aimed at enhancing the protections afforded to investors in private funds that are managed by private fund advisers. The new rules are set forth in Release No. IA-6383, Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews (“Final Rules”). The Final Rules “grandfather in” (i.e., provide “legacy status” to) only certain specific aspects of the preferential treatment rule (new Rule 211(h)(2)-3) and the restricted activities rule (new Rule 211(h)(2)-1) that apply to existing funds, so private fund advisers will need to consider the impact the Final Rules may have on their management of existing private funds, as well as new funds being established.

Approved by a 3-2 vote at the SEC, the Final Rules have been pared back from the proposed rules issued in February 2022 but are still expected to have a major impact on the management and operations of private fund advisers.  They are intended to achieve various key objectives for protecting investors in private funds, including the following:

• Providing better transparency and reporting to private fund investors - by increasing visibility into certain practices and mandating that quarterly statements containing specified information, including information on fees and expenses and performance, be sent to investors;
• Restricting certain practices without disclosure or investor consent - such as charging or allocating to the private fund fees and expenses that are associated with compliance, investigation or examination of the adviser or its related persons without certain required disclosures or obtaining investor consent;
• Requiring annual financial statement audits – by requiring private funds to be audited annually by a PCAOB-registered and regulated independent public accountant and the certified annual report distributed to private fund investors;
• Avoiding preferential treatment towards certain investors – by prohibiting preferential treatment to particular investors through side letters if the treatment would have a material, negative effect on other investors, and restricting other practices that confer preferential treatment unless there is adequate disclosure of the arrangement and, in some cases, the consent of investors; and
• Avoiding conflicts of interests in adviser-led secondary transactions – by requiring a fairness opinion or valuation opinion issued by an independent opinion provider to be obtained in connection with secondary transactions that are led by a private fund adviser to a transacting private fund (e.g., an investor being offered the option to convert or exchange its interests for those in a continuation fund managed by the same adviser), and distributed to investors in this fund.

In adopting the Final Rules, the SEC also made corresponding changes to other rules under the Advisers Act, such as Rule 204-2 (for maintaining the adviser’s books and records in respect of the quarterly statement, audit, adviser-led secondaries, preferential treatment and restricted activities rules) and Rule 206(4)-7 (for maintaining the adviser’s written compliance policies and policies and to require all SEC-registered advisers of private funds document their annual review in writing).

Notably, the Final Rules omitted a proposed rule which would have prohibited advisor indemnification and exculpation for negligence in connection with providing services to a private fund, despite general market acceptance and comfort with the gross negligence standard. 

The Final Rules apply to varying degrees to both registered private fund advisers and private fund advisers that are exempt from registration under the Advisers Act, as well as advisors that are registered but do not advise private funds. The Final Rules contain important exceptions for investment advisers to “securitized asset funds” – i.e., private funds whose primary purpose is to issue asset-backed securities and whose investors are primarily debt holders. Advisers to these funds are not subject to any of the requirements of the new rules. 

The Final Rules become effective 60 days after the date of publication in the Federal Register, but have different transition periods and compliance dates. For purpose of complying with the Annual Audit Rule (Rule 206(4)-10) and the Quarterly Statement Rule (Rule 211(h)(1)-2), all SEC-registered private fund advisers are required to comply 18 months after publication of the rules in the Federal Register. For compliance with all of the other Final Rules, the compliance date varies: if the adviser has less than $1.5 billion of assets under management attributable to private funds, the adviser has 18 months from the date of publication in the Federal Register in which to comply; if the adviser has assets under management attributable to private funds of $1.5 billion or more, the adviser has 12 months from the date of publication in the Federal Register in which to comply. For the Compliance Rule Amendments (Rule 206(4)-7), the compliance date for all registered fund advisers (including those that do not advise private funds) is 60 days after publication in the Federal Register.           

Additional discussion and analysis of the key elements of the Final Rules are set forth below. The Dentons Private Funds Team expects to provide additional analysis on certain aspects of the Final Rules and on any developments that may affect  the implementation of the Final Rules.

Effect on SEC-Registered Private Fund Advisers

Quarterly Statement Rule

The Final Rules require SEC-registered private fund advisers to provide investors with quarterly statements containing information about private fund fees, expenses and performance, as well as compensation received (and any related fee offsets) from funds and their portfolio companies. Fund advisers must deliver quarterly statements to all investors in their funds within 45 days after the fiscal quarter end (Q1 through Q3) and within 90 days for the fourth fiscal quarter (each of those timeframes is extended by 30 days for funds of funds), which reports must comply with specific formatting and disclosure requirements. Additionally, for both fee and expense disclosures and performance disclosures, such data must be consolidated for substantially similar pools of assets to the extent doing so would provide more meaningful info to the investors and would not be misleading (such consolidation would apply to master feeder-feeder fund structures and the like).  Advisers to illiquid funds (as further described below) are required to calculate performance information both with and without the impact of subscription credit facilities.  Advisers to liquid funds must present performance on a 10-year lookback basis (rather than since inception if more than 10 years ago). 

Fee and expense disclosures

The quarterly reports must disclose private fund fees and expenses in a table format that includes  the following information: (1) a detailed accounting of all compensation, fees, and other amounts allocated or paid to the adviser or its related persons by the private fund during the reporting period; (2) a detailed accounting of all fees and expenses allocated to or paid by the private fund during the reporting period other than those disclosed in clause (1) (including organizational, accounting, legal, administration, audit, tax, due diligence, and travel fees and expenses); and (3) the amount of any offsets or rebates carried forward during the reporting period to subsequent quarterly periods to reduce payments or allocations to the adviser or its related persons.  These items include, but are not limited to, management, advisory, sub-advisory or similar fees, as well as performance-based fees, which is broadly defined.

The quarterly statements rule also requires the disclosure of a detailed accounting of all portfolio investment compensation allocated or paid by each “covered portfolio investment” during the reporting period to the extent attributable to a private fund’s interest in a covered portfolio investment. This includes holding companies, special purpose vehicles, subsidiaries, and other entities in which a private fund has invested directly or indirectly. The amounts called for here would not include any fees or other compensation attributable to any other person’s interest in the covered portfolio investment (i.e., a co-investor). As with fund-level disclosures, separate line items are required for each category of allocation or payment (i.e., origination, management, consulting, monitoring, servicing, administrative, disposition, directors, trustees or similar fees) by the covered portfolio investment to the adviser or its related persons. 

Further, the disclosures at both the fund and portfolio company levels must include the amount both before and after the application of any offsets, rebates or waivers, in addition to those that are carried forward during the reporting period to reduce future payments or allocations to the adviser or its related persons.

The adviser must also prominently disclose the manner in which the reported values for all payments, expense, allocations, rebates, waivers and offsets are calculated, including cross-references to the relevant sections of the private fund’s organizational and offering documents.

Performance disclosures

In addition to fees and expenses,  the quarterly statements rule requires private fund advisers to include standardized private fund performance information in each report. The rule differentiates between liquid and illiquid private funds. Illiquid private funds are generally defined as private funds that do not have to redeem investors’ interests upon request and  provide limited opportunities, if any, for investors to withdraw before termination of the fund. Liquid private funds, by contrast, are defined as every other type of private fund. The required performance disclosures must also include adequate disclosure of the criteria used and assumptions made in calculating such performance.

To comply with this requirement, liquid fund advisers must disclose, with equal prominence, the net total return on an annual basis for the 10 fiscal years prior to the quarterly statement or since the fund’s inception (whichever is shorter) over the past 1, 5, and 10 fiscal year periods, the average annual net total returns over such 1, 5 and 10 fiscal year periods, and the cumulative net total return for the current fiscal year as of the end of the most recent fiscal quarter. 

Illiquid fund advisers appear to have a more burdensome performance disclosure requirement under the Final Rules. Under the quarterly statements rule, the adviser must present performance data for each illiquid private fund (i) since inception through the end of the quarter covered by the quarterly statement, and (ii) with and without the impact of any fund-level subscription facilities. The following metrics must be provided to investors with equal prominence: (i) the gross internal rate of return (“IRR”) and gross multiple on invested capital (“MOIC”) (for both the realized and unrealized portions of the portfolio, shown separately); (ii) net IRR and net MOIC; (iii) a statement of contributions and distributions since inception; and (iv) the net asset value as of the end of the reporting period. Definitions for both IRR and MOIC are included in the Final Rules.

Annual Audits Rule

The Final Rules mandate that SEC-registered private fund advisers conduct annual audits of each private fund they manage (other than a securitized asset fund). These audits must comply with the same standards as the “custody rule” (Rule 206(4)-2 under the Advisers Act) requirements and be conducted by an independent public accountant that is registered and subject to regular inspection by the Public Company Accounting Oversight Board (PCAOB). The Annual Audits Rule contains additional requirements, such as the requirement that  private fund financial statements be prepared in accordance with Generally Accepted Accounting Principles (GAAP) and be distributed  to investors within 120 days of its fiscal year-end (180 days for a fund of funds).

Adviser-Led Secondaries Rule

The Final Rules require SEC-registered private fund advisers to obtain either a fairness opinion or a valuation opinion issued by an independent opinion provider meeting certain expertise and independence requirements in connection with any adviser-led secondary transaction involving a private fund for which it serves as investment adviser. The option to obtain a valuation opinion for these transactions, rather than a fairness opinion, represents a change from the proposed rules, and is generally regarded as a less stringent process and opinion as compared to a fairness opinion. Secondary transactions are defined as any transaction initiated by the adviser or its affiliates that offer investors in its private fund(s) the option to sell the investors’ interests in the fund, or convert or otherwise exchange such interests, to another investment vehicle controlled by the adviser or its affiliates. In addition, SEC-registered advisers must prepare and distribute a written summary of any material business relationships the adviser or any of its related persons has or had within the prior two (2) years with the independent opinion provider. 

Effect on All Private Fund Advisers (whether registered or not)

Preferential Treatment Rule

All private fund advisers, whether registered or not (including their related persons), are prohibited under Final Rule 211(h)(2)-3 (the “preferential treatment rule”) from providing preferential treatment to investors with respect to redemption rights and certain information rights that the adviser reasonably expects would have a material, negative effect on other investors. Under this provision, the adviser is prohibited from granting an investor the ability to redeem its interests in the private fund or similar pool of assets, except in the following two instances: (1) if the ability to redeem is required by applicable law, or (2) if the adviser offers the same ability to redeem to all other existing investors in the private fund or similar pool of assets, and will continue to offer this right to all future investors in the private fund or pool of assets. For this purpose, a “similar pool of assets” means a pooled investment vehicle (other than a registered investment company, a business development company that has made an election to be regulated as an investment company, or a securitized asset pool) that has substantially similar investment policies, objectives or strategies to those of the private fund.  The term, therefore, may include co-investing funds, parallel funds, feeder funds, etc. that fit the definition in the rule.

An adviser is also prohibited under the preferential treatment rule from providing information regarding the portfolio holdings or exposures of the private fund or similar pool of assets to any investor in the private fund if the adviser reasonably expects that providing this information would have a material, negative effect on other investors. The one exception here is if the adviser provides this information to all other existing investors in the private fund at the same time or substantially the same time.  The SEC has indicated that preferential information rights provided to an investor in an illiquid private fund would not generally be viewed as having a material, negative effect on other investors.

An adviser may grant other types of preferential treatment to an investor in a private fund or similar pool of assets, provided that adequate disclosure in the form of a written notice is given to all other investors in the private fund or similar pool of assets (and, presumedly, the preferential treatment would not relate to redemption rights or information rights that have a material, negative effect on the other investors). The nature of and time for distributing the disclosure depends on whether the investor is a prospective investor or a current investor in the private fund and whether the fund is a liquid private fund or an illiquid private fund.

For prospective investors, the adviser must provide written disclosure of preferential treatment relating to any material economic terms (such as the cost of investing, liquidity rights, fee breaks, and co-investment rights) before the investor makes its investment in the fund. For current investors, in the case of an illiquid fund, the adviser must deliver a written notice, as soon as reasonably practicable following the end of the private fund’s fundraising period, disclosing  all  preferential treatment (including non-economic terms) the adviser or its related person has provided to other investors in the same private fund. For current investors, in the case of a liquid fund, the adviser must deliver written notice, as soon as reasonably practicable following the investor’s investment in the private fund, disclosing all preferential treatment (including non-economic terms) the adviser or its related person has provided to other investors in the same private fund.

The adviser is also required to distribute an annual written notice to current private fund investors where the notice provides specific information about any preferential treatment the adviser or its related person provides to other investors in the same private fund since the last written notice.

An adviser can comply with its written disclosure obligations by (i) providing copies of any side letters with preferential terms to all investors in the fund (with identifying information of the other investors redacted) or (ii) providing a written summary of the preferential terms, as long as the summary has sufficient and specific detail of such terms.  SEC-registered advisers must maintain the required books and records to support their compliance with the preferential treatment rule, in accordance with amendments adopted to Rule 204-2.

Restricted Activities Rule

The Final Rule (Rule 211(h)(2)-1) restricts private fund advisers from engaging in certain activities unless specific disclosures are made and, in some cases, investor consent is obtained as further described below. 

Disclosure-Based Exceptions

Restricted activities with disclosure-based exceptions include the  following: (1) charging or allocating to the private fund any regulatory, compliance or examination fees or costs of the adviser or its related persons; (2) reducing any “adviser clawback” obligation (i.e., an obligation to restore or otherwise return any performance-based compensation pursuant to the governing documents of the fund) by the amount of any actual, potential or hypothetical taxes applicable to the adviser or its affiliates, or the respective owners thereof; and (3) charging or allocating fees and/or expenses related to a portfolio investment on a non-pro-rata basis when there are multiple vehicles or clients advised by the same adviser or its affiliates investing in the same portfolio investment (including any “broken deal” expenses for unconsummated transactions). 

The Final Rules require the adviser to provide written notice of any regulatory, compliance or examination fees or costs, and the dollar amounts thereof, to investors in a private fund on at least a quarterly basis, if such fees or costs are to be charged or allocated to the private fund. 

Similarly, with respect to adviser clawbacks, the adviser is required to distribute a written notice to investors setting forth the aggregate dollar amount of the adviser clawback both before and after any such reduction for actual, potential or hypothetical taxes, within 45 days after the end of the fiscal quarter in which the adviser clawback occurs, if the clawback will be reduced accordingly.  The ”adviser clawback” rule will likely affect a large number of advisers, given that many net taxes against the adviser clawback obligation.  Any adviser with such a netting mechanism will likely need to either adopt the disclosure approach or amend the governing documents in compliance with the rules.

Non-pro rata allocations are restricted unless two requirements are met: (1) the non-pro rata allocation must be fair and equitable under the circumstances; and (2) before charging or allocating such fees and expenses to a private fund client, the adviser must distribute to each investor in 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. The SEC recognized that private fund advisers may structure investments for specific tax, regulatory, accounting or other reasons for the benefit of certain investors, and that the framework provided offers investors additional protections while simultaneously offering advisers the flexibility to execute investment strategies and offer a diversity of investment structures in a way that may benefit investors. However, the non-pro rata allocation rule may impact the ability to engage in co-investments where such fees and expenses are not charged on a pro-rata basis. Advisers would be well advised to review their applicable private fund’s and co-investment vehicle’s organizational documents in any existing portfolio co-investments in order to ascertain whether fees and expenses are allocated pro rata among all participating adviser-advised vehicles and clients or whether any amendments or revisions are required prior to the compliance date for the Final Rules.

Consent-Based Exceptions

Restricted activities with certain investor consent exceptions are as follows: (1) charging or allocating to the private fund any fees or expenses associated with the investigation of the adviser or its related persons by any governmental or regulatory authority, except that charging or allocating fees or expenses arising from sanctions imposed for violating the Advisers Act or rules promulgated thereunder are flatly prohibited; and (2) borrowing, directly or indirectly, money, securities or other fund assets (or otherwise receiving a loan or extension of credit) from a private fund client. 

In order to charge fees or expenses associated with an investigation of the adviser or its related persons (other than those relating to sanctions), the private fund adviser must seek consent from all investors of a private fund and obtain written consent from at least a majority in interest of the fund’s investors that are not related persons of the adviser. In the event that any fees or expenses charged to investors in connection with an investigation ends up being the subject of a sanction, the adviser must refund the fees and expenses charged or allocated to the fund in connection with such investigation. 

Similarly, in order to engage in borrowings from a private fund client, the adviser must distribute a written notice and description of the material terms of the borrowing to the investors of the private fund, seek their consent, and obtain written consent from at least a majority in interest of the fund’s investors that are not related persons of the adviser. Although the material terms are intentionally not defined, the SEC indicated those could include the amount of money to be borrowed, interest rate and the repayment schedule, depending on the facts and circumstances.

Effect on All Registered Advisers (regardless of whether they advise private funds or not)

Compliance Rule Amendments

In adopting the Final Rules, the SEC amended Rule 206(4)-7 under the Advisers Act to require all SEC-registered investment advisers, including those that do not advise private funds, to document in writing the required annual review of their compliance policies and procedures. This essentially codifies the current SEC position.  There is no specified format for the documentation.  All SEC-registered advisers are required to comply with amended Rule 206(4)-7 within 60 days after publication in the Federal Register.