SEC Adopts Expansive Private Fund Adviser Rules – Securities

On August 23, 2023, the SEC adopted new rules and amendments to existing rules
(collectively, the “New Rules“) under
the Investment Advisers Act of 1940 (the “Advisers
Act“). The New Rules are designed to increase
transparency for private fund investors, address conflicts of
interest that the SEC staff believes are “commonly
present” in private fund adviser practices, and address
perceived risk of harm to private fund investors arising from
private fund governance structures.

Investment advisers affected by the New Rules should not
underestimate the time or cost necessary to implement the
requirements of the New Rules. The New Rules represent a
significant shift in the amount and types of disclosure that will
be required to be provided to investors in private funds. In some
cases (e.g., the audit rule discussed below), private fund advisers
may need to identify and enter into contracts with new service
providers. In short, advisers will need to significantly overhaul
their compliance and operational procedures in a relatively short
timeframe to ensure compliance with these new requirements.

While the New Rules remain subject to challenge and certain
aspects of the New Rules require further clarification, the outline
below sets forth a high-level overview of the New Rules (as
currently drafted) and their potential impact on the key players in
the industry – namely investment advisers and private fund
investors. Our FAQ page sets out responses to our
clients’ most frequently asked questions on the New Rules.

This overview and our FAQ responses are intended to provide
investment advisers and other professionals with a general overview
of the information contained in SEC Release No. IA-6383. Industry
practice will undoubtedly evolve as the New Rules are clarified,
further interpreted, and implemented.

Summary of the New Rules:

Among other things, the New Rules:

• require registered investment advisers that manage private
  funds to:




• • obtain an audit of private funds that is consistent with
    existing obligations under the Advisers Act custody rule;

  
  

  • provide quarterly statements to investors in each fund,
    including standardized performance reporting;

  
  

  • obtain either a fairness opinion or a valuation opinion in
    connection with GP-led secondaries; and

  
  

  • memorialize the adviser’s annual review of its compliance
    program in a written report;




• restrict all advisers (including exempt reporting advisers)
  that manage private funds (other than securitized asset funds) from
  certain activities (largely related to the allocation of fees and
  expenses to investors and certain sales practices) without
  disclosure to investors and, in some cases, consent of investors
  (referred to as the “restricted activities rule”);
  and




• prohibit all advisers (including exempt reporting advisers)
  that manage private funds from entering into side letters that
  result in preferential treatment with respect to redemption rights
  and portfolio holdings or exposure information (referred to as the
  “preferential treatment rule”). The preferential
  treatment rule also imposes new disclosure obligations related to
  side letters.

Compliance Timeline

The New Rules will be effective 60 days after the date of
publication in the Federal Register. Investment advisers will have
between 60 days and 18 months to come into compliance with the New
Rules, as set forth below:

• Implementation of the New Rules related to private fund audits
  and distribution of quarterly statements is required within
  18-months for all registered private fund advisers.




• Advisers with $1.5 billion or more in private funds assets
  under management must adhere to a 12-month transition period for
  the adviser-led secondaries rule, the preferential treatment rule,
  and the restricted activities rule.




• Advisers with less than $1.5 billion in private fund assets
  under management will have 18-months to comply with the adviser-led
  secondaries rule, the preferential treatment rule, and the
  restricted activities rule.




• Compliance with the amended Advisers Act compliance rule will
  be required 60 days after publication in the Federal Register.

Legacy Provision. If
the application of either the restricted activities rule or the
preferential treatment rule would require an investment adviser and
a private fund that has commenced operations as of the compliance
date of the New Rules to amend written contractual agreements
governing the fund that were entered into prior to the compliance
date of the New Rules, then the investment adviser and the private
fund will not be required to amend such contractual arrangements.
Private fund advisers should be aware that, for purposes of the
disclosure requirements in the preferential treatment rule, certain
information in existing side letters, other than the specific
investor that received a preferential term, will be disclosed to
other investors that invest in a fund post compliance date.

For purposes of claiming legacy status, “commencement of
operations” includes, for example, issuing capital calls,
setting up a subscription facility for the fund, holding an initial
fund closing, conducting due diligence on potential fund
investments, or making an investment on behalf of the fund.
Contractual agreements covered by the legacy provision must be in
writing and include, but are not limited to, a private fund’s
operating or organizational agreements (e.g., the limited
partnership agreement, the limited liability company agreement,
articles of association, or by-laws), the subscription agreements,
side letters, promissory notes, and credit agreements.

Key Provisions – Registered Investment Advisers

Quarterly Statements.
Registered investment advisers will be required to provide
investors in private funds managed by the advisers with quarterly
statements including information related to fees and expenses paid
by investors in the fund and performance received on such
investments over the preceding quarter. The SEC noted that this
information will “improve investors’ ability to evaluate
the adviser’s conflicts of interest with respect to the fees
and expenses charged to the fund by the adviser and the performance
metrics that the adviser presents to investors.”

Quarterly statements are due within 45 days of the end of the
first three quarters of the year (75 days for funds of funds) and
within 90 days after the end of the fiscal year (120 days for funds
of funds).

Quarterly statements will be required to include:

• A table that includes the following data (both before and after
  the offset of offsets, rebates, or waivers):




• • all compensation, fees, and other amounts (e.g., management,
    advisory, sub-advisory, or similar fees or payments, and
    performance-based compensation) allocated or paid to the investment
    adviser or any of its related persons by the private fund during
    the reporting period;

  
  

  • all other fees and expenses allocated to or paid by the private
    fund during the reporting period including, but not limited to,
    organizational, accounting, legal, administration, audit, tax, due
    diligence, and travel fees and expenses; and

  
  

  • the amount of any offsets or rebates carried forward during the
    reporting period.




• A table summarizing all compensation, fees, and other amounts
  allocated or paid to the investment adviser or any of its related
  persons by portfolio companies that is attributable to the private
  fund’s interest in such portfolio companies, including, but not
  limited to, origination, management, consulting, monitoring,
  servicing, transaction, administrative, advisory, closing,
  disposition, directors, trustees, or similar fees or payments.




• Prominent disclosure regarding the manner in which all
  expenses, payments, allocations, rebates, waivers, and offsets are
  calculated, including cross references to the sections of the
  private fund’s organizational and offering documents that set
  forth the applicable calculation methodology.




• In the case of a private fund with limited redemption and
  withdrawal rights (an “illiquid fund”), the following
  performance measures, calculated since inception of the illiquid
  fund through the end of the quarter covered by the quarterly
  statement and computed both with and without the impact of any
  fund-level subscription facilities:




• • gross and net internal rates of return (IRR) for the fund as a
    whole;

  
  

  • gross and net multiples of invested capital (MOIC) for the fund
    as a whole;

  
  

  • gross IRR and gross MOIC for the realized and unrealized
    portions of the illiquid fund’s portfolio, with the realized
    and unrealized performance shown separately; and




• a statement of contributions and distributions.




• In the case of all other private funds (“liquid
  funds”):




• • annual net total returns for each fiscal year over the past 10
    fiscal years or since inception, whichever time period is
    shorter;

  
  

  • average annual net total returns over the one-, five-, and
    10-fiscal-year periods; and

  
  

  • cumulative net total return for the current fiscal year as of
    the end of the most recent fiscal quarter covered by the quarterly
    statement.

Mandatory Private Fund
Audits. Registered investment
advisers to private funds will be required to obtain an annual
financial statement audit of the private funds they advise,
directly or indirectly. The SEC noted that the audit requirement
is, among other things, designed to provide a check on the
adviser’s valuation of private fund assets, as well as testing
of the calculation and presentation of management fees and
performance fees due to the adviser or tis related persons.

The audit requirement is based on, and largely consistent with,
the requirements of Rule 206(4)-2 under the Advisers Act (the
“Custody Rule”). Accordingly, among other things:

• Audits must be performed by an independent public accountant
  that meets the standards of independence in Regulation S-X and that
  is registered with, and subject to regular inspection by the Public
  Company Accounting Oversight Board (“PCAOB”);




• Audited financial statements must be prepared in accordance
  with generally accepted accounting principles; and




• Annually, within 120 days of the private fund’s fiscal
  year-end, and promptly upon liquidation, the private fund’s
  audited financial statements must be delivered to investors in the
  private fund.

In the case of a private fund that is neither controlled by nor
under common control with the adviser (e.g., a fund of funds that
invests in underlying funds managed by unaffiliated sub-advisers)
the adviser need only take “all reasonable steps” to
cause the underlying private fund to undergo such an audit.

Adviser-Led
Secondaries. Registered investment
advisers that initiate a transaction that offers investors in a
private fund the option between selling all or a portion of their
interest in the private fund or converting or exchanging such
interests for new interests in another vehicle advised by the
adviser or its related persons will be required to:

• obtain a fairness opinion or a valuation opinion from an
  independent opinion provider and distribute the opinion to private
  fund investors prior to the due date of the election form; and




• prepare and distribute a written summary of any material
  business relationships between the adviser or its related persons
  and the independent opinion provider.

The SEC noted that adviser-led secondaries create a conflict of
interest between a private fund and its registered investment
adviser, because the adviser is incentivized to recommend that a
private fund sell its assets to a continuation vehicle because the
adviser and its related persons will typically receive additional
management fees and carried interest from managing the continuation
vehicle. By ensuring that private fund investors that participate
in a secondary transaction are offered an appropriate price and
provided disclosures about the opinion provider’s relationship
with the adviser, the SEC believes that this rule will reduce the
possibility of fraudulent, deceptive, or manipulative activity on
the part of investment advisers.

Although intended to protect investors, fairness and valuation
opinions are subject to numerous assumptions and speak only to the
fairness or valuation of the transaction consideration as of a
particular date, which usually precedes the closing date. Fairness
opinions are not necessarily responsive when consideration is not
solely cash. Furthermore, the cost burden of obtaining such
opinions is likely to be passed on to investors.

Under the New Rules registered investment advisers and investors
in the private funds that they manage will have the ability to
negotiate whether a fairness opinion or valuation opinion is more
appropriate.

Annual Compliance Written Report.The
New Rules include amendments to Rule 206(4)-7, the compliance rule
under the Advisers Act, that will require all 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 rule does not prescribe a specific format of the
written document, and investment advisers will be free to determine
the report that works best for them.

Written documentation of the annual review will help the
SEC’s examination staff to determine if advisers are complying
with the compliance rule. The new requirement will also, of course,
potentially provide a roadmap for potential referrals to the
SEC’s enforcement staff.¹ The SEC noted that any
request for the written report should be promptly²
produced to SEC staff upon request. Moreover, the SEC cautioned
advisers against seeking to rely on “improper claims of
attorney-client privilege, the work-product doctrine or other
similar protections.”

Key Provisions – All Advisers (including Exempt Reporting
Advisers)

Restricted Activities
Rule. An investment adviser to a
private fund (other than a securitized asset fund) may not,
directly or indirectly, do the following with respect to the
private fund, or any investor in that private fund:

• charge or allocate to the private fund fees or expenses
  associated with an investigation of the adviser without disclosure
  to and seeking consent from all fund investors and receiving
  written consent from at least a majority of fund investors that are
  not related persons of the investment adviser;




• under any circumstances, charge 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 or the rules promulgated thereunder;




• charge or allocate to the private fund regulatory, examination,
  or compliance fees or expenses of the adviser, unless such fees and
  expenses are disclosed to investors in a written notice, including
  the total dollar amount of such fees or expenses, within 45 days
  after the end of a fiscal quarter in which such charge occurs;




• reduce the amount of an adviser’s clawback by the amount of
  actual, potential, or hypothetical taxes applicable to the
  investment adviser or its related persons, unless the adviser
  discloses in writing the pre-tax and post-tax amount of the
  clawback to investors within 45 days after the end of the fiscal
  quarter in which the clawback occurs;




• charge or allocate fees or expenses related to a portfolio
  company 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 and a description of the proposed
  charge or allocation and why its approach is fair and equitable
  under the circumstances; and




• borrow or receive an extension of credit from a private fund
  client without disclosure to all investors and receipt of written
  consent from at least a majority of fund investors that are not
  related persons of the investment adviser.

The enhanced disclosure requirements related to the restricted
activities rule will increase compliance burdens and associated
regulatory costs for all investment advisers, even if such
investment advisers are successful in maintaining their current
practices of charging the fees, expenses and indemnification
reimbursements described above to the private funds they advise.
The restricted activities rule and the New Rules in general are
likely to enhance the risk of regulatory action, including public
regulatory sanctions. If an investment adviser is prohibited from
passing on related costs to the private funds it advises, either by
way of categorizing such fees and expenses as partnership expenses
or seeking indemnification reimbursement, the investment adviser
will need to bear such amounts and the cost of insurance,
specifically D&O and E&O insurance, could significantly
increase or such insurance coverage may become unavailable, as a
consequence.

Preferential Treatment
Rule. The New Rules prohibit all
investors advisers to private funds (excluding securitized asset
funds) from directly or indirectly:

• giving an investor in a private fund the right to redeem its
  interest on terms that the adviser reasonably expects to have a
  material, negative effect on other investors in that private fund
  or in a similar pool of assets, unless the ability to redeem is
  required by applicable law or the adviser offers the preferential
  redemption rights to all other existing and future investors in
  that private fund without qualification; and




• providing preferential information about portfolio holdings or
  exposures of the private fund if the adviser reasonably expects
  that providing the information would have a material, negative
  effect on other investors in that private fund, unless such
  preferential information is offered to all existing investors in
  the private fund at the same time.

The preferential treatment rule prohibits all private fund
advisers from providing such preferential treatment to any investor
in a private fund, unless:

• the investment adviser provides to each prospective investor in
  the private fund a written notice that provides information
  regarding any preferential treatment related to any material
  economic terms that the adviser or its related persons provide to
  other investors in the private fund;




• the investment adviser distributes to current investors in
  illiquid funds, as soon as reasonably practicable following the end
  of the private fund’s fundraising period, written disclosure of
  all preferential treatment the adviser or its related persons has
  provided to other investors in the private fund;




• the investment adviser distributes to each investor in a liquid
  fund, as soon as reasonably practicable following an investor’s
  investment in a private fund, written disclosure of all
  preferential treatment the adviser or its related persons has
  provided to other investors in the private fund; and




• on at least an annual basis, the investment adviser distributes
  a written notice to all investors in a private fund managed by that
  adviser that provides specific information regarding any
  preferential treatment provided by the adviser or its related
  persons to other investors in the private fund since the last such
  written notice, if any.

The preferential treatment rule is intended to enhance
transparency during the negotiation process and protect investors
by prohibiting specific types of preferential treatment, unless
required by applicable law, that could have a material dilutive or
negative effect on other investors. The preferential treatment rule
will undoubtedly alter advisers’ practices with respect to side
letters and most favored nations (“MFN”) processes. Terms
that advisers may have been willing to grant select investors in
the past on the basis that they would not need to be disclosed
and/or offered to other investors (such as under an MFN provision)
may become more controversial, with advisers becoming more hesitant
to grant these terms if they need to be disclosed and/or offered to
all investors. Investors will need to reevaluate whether obtaining
these terms are absolute requirements for them and whether any
redemption rights they previously requested can be described as
being required by applicable law, rather than internal policy.
Advisers’ hesitancy to grant terms they previously agreed to
will likely result in extended side letter negotiations, increasing
a fund’s organizational costs and the investor’s own legal
costs related to the investment.

Changes from the Proposal

Proposed Waiver of
Indemnification. The New Rules do
not include the proposed rule that would have prohibited an adviser
to a private fund, directly or indirectly, from seeking
reimbursement, indemnification, exculpation, or limitation of
liability for (among other things) ordinary negligence. This change
is consistent with comments made by many in the industry raising
concerns that, among other things, the proposed prohibition would
have resulted in “more onerous liability standards for
sophisticated investors than for retail investors and that such a
difference would result in better protection for institutional
investors than for investors in retail products.”

Instead, the SEC took the opportunity to reaffirm and clarify
“its views on how an adviser’s fiduciary duty applies to
its private fund clients and how the antifraud provisions apply to
the adviser’s dealings with clients and fund investors.”
The SEC staff reiterated its position that any waiver of an
adviser’s obligations under the Advisers Act, including its
fiduciary duty and compliance with the anti-fraud provisions in
Section 206 of the Advisers Act, is invalid.

The SEC noted that, if a contractual clause that purports to
limit an adviser’s liability creates a conflict of interest
between an adviser and its client (i.e., a private fund) then the
adviser “must address the conflicts as required by its duty of
loyalty.” Moreover, the SEC stated that it believes that
“an adviser may not seek reimbursement, indemnification, or
exculpation for breaching its Federal fiduciary duty because such
reimbursement, indemnification, or exculpation would operate
effectively as a waiver, which would be invalid under the
Act.” Similarly, the SEC would consider an adviser that
charges to its private fund clients fees and expenses related to an
investigation that results in the imposition of sanctions against
the adviser for a violation of the Advisers Act and its related
rules to be invalid under the Advisers Act.

The SEC’s comments underscore their enhanced scrutiny of
investment advisers’ practices with respect to addressing
conflicts and narrowing fiduciary duties by contract. Investment
advisers should carefully review how conflicts are being addressed
in the governing documents for the private funds they advise and
ensure they are in-line with the views expressed above.

No SEC Notification by
Auditors. The proposed rules would
have required a registered adviser to a private fund to enter into,
or cause the private fund to enter into, a written agreement with
the independent public accountant performing the private fund audit
to notify the SEC (i) “promptly” upon issuing an audit
report to the private fund that contained a modified opinion and
(ii) within four business days of resignation or dismissal from, or
other termination of, the engagement, or upon removing itself or
being removed from consideration for being reappointed. The SEC
stated that it decided not to adopt this reporting requirement in
order to align the audit requirement with those in the Custody
Rule. However, the SEC’s currently proposed safeguarding
rule³ would require advisers to enter into a similar
written agreement with the independent public accountant performing
the audit.

Fees for Unperformed
Services. The SEC also determined
not to adopt a proposed prohibition on charging portfolio companies
for monitoring, servicing, consulting, or other fees related to
services that an investment adviser does not, or does not
reasonably expect to, provide to the portfolio company. The SEC
stated that such prohibition was not necessary since such activity
“would cause the adviser to place its own interests ahead of
its client’s interests, as more fully described in the
paragraph below, we have determined that it is unnecessary to
prohibit activity that is already indirectly inconsistent with the
adviser’s fiduciary duty.”

Footnotes

1. Advisers in an organization that includes multiple
investment advisers should note that the change to the compliance
rule under the Advisers Act will require each individual adviser to
produce the required written report of the annual compliance
review.

2. In a note to the adopting release, the SEC noted that
it expects that a fund or adviser would be permitted to delay
furnishing electronically stored records for more than 24 hours
only in unusual circumstances.

3. On the same day it adopted the New Rules, the SEC
reopened comments on its proposed Enhanced Safeguarding Rule for
Registered Investment Advisers which, as proposed would redesignate
and amend the Custody Rule.

Because of the generality of this update, the information
provided herein may not be applicable in all situations and should
not be acted upon without specific legal advice based on particular
situations.

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