The proposal would prohibit all private fund advisers from engaging in certain activities, place certain obligations on registered private fund advisers, and require all registered advisers to document the annual review of their compliance policies and procedures in writing.
On February 9, 2022, the U.S. Securities and Exchange Commission (SEC) proposed new rules and amendments under the Investment Advisers Act of 1940 (the Act) to enhance the regulation of private fund advisers. According to the rule release, the SEC proposed these reforms “to address concerns that arise out of the opacity that is prevalent in the private fund structure.” This proposal comes on the heels of Chair Gary Gensler’s push for increased transparency in private funds and improvements to the protection of investors in private funds.
The proposed new rules and amendments include:
- Quarterly reporting requirements.
- Fund audit requirements.
- Independent fairness opinion for Adviser-led transactions.
- Six newly prohibited activities.
- Prohibitions and requirements regarding preferential treatment.
- Requirement to document the annual rule 206(4)-7 review in writing.
The SEC proposed these rules to address certain practices it observed to be contrary to the public interest and protection of investors. For example, the SEC considers there to be an information imbalance between private fund advisers and private fund investors due to the lack of transparency by private fund advisers regarding costs, performance and preferential treatment. The SEC also noted several instances of conflict of interest that involve problematic sales practices or compensation schemes, instances where advisers seek to limit their fiduciary duty and the general lack of strong governance at private funds.
New Requirements for Registered Private Fund Advisers
1. Quarterly Statement Rule
A registered private fund adviser would be required to prepare a quarterly statement that includes information regarding fees, expense and standardized performance metrics and distribute — either through paper or electronic means — the quarterly statement to the private fund’s investors within 45 days after each calendar quarter end. The quarterly statement must include certain elements:
- Fee and Expense Disclosure
Fund-Level Disclosure. The adviser would be required to include in the quarterly statement a “fund table” detailing all adviser compensation and fund fees/expenses. The adviser compensation would include amounts allocated or paid to related persons for management, advisory, sub-advisory or similar fees or payments and performance-based compensation. The fund fees and expenses would include all fund fees and expenses paid during the reporting period including, but not limited to, organizational, accounting, legal, administration, audit, tax, due diligence and travel expenses. The rule would require that such adviser compensation and fund expenses be disclosed before and after the application of any offsets, rebates or waivers.
Portfolio Investment-Level Disclosure. The adviser would be required to include in the quarterly statement a separate “portfolio investment table” detailing for each covered portfolio investment all compensation as well as the fund’s ownership percentage of each such covered portfolio investment. The portfolio investment compensation would include compensation allocated or paid by each covered portfolio investment to the investment adviser or any of its related persons for origination, management, consulting, monitoring, servicing, transaction, administrative, advisory, closing, disposition, directors, trustees or similar fees or payments by the covered portfolio investment.
Calculations and Cross References to Organizational and Offering Documents. The rule would also require each statement to include prominent disclosure regarding how expenses, payments, allocations, rebates, waivers and offsets are calculated and must include cross references to the relevant sections of the private fund’s organizational and offering documents that set forth the calculation methodology.
- Performance Disclosure
A registered private fund adviser would also be required to include in the quarterly statement standardized fund performance information depending on whether a fund as defined by the rule is Liquid (i.e., most hedge funds) or Illiquid (i.e., many private equity, real estate and venture capital funds). In addition, the adviser must include in the quarterly statement a prominent disclosure of the criteria used and assumptions made in calculating the performance.
Liquid Funds. The quarterly report for Liquid funds would include performance based on (i) annual net total returns for each calendar year since inception, (ii) average annual net total returns over the one-, five-, and ten-calendar-year periods, and (iii) cumulative net total returns for the current calendar year as of the end of the most recent quarter covered by the quarterly statement.
Illiquid Funds. The quarterly report for Illiquid funds would include performance based on (i) the gross and net internal rate of return, (ii) gross and net multiple of invested capital, and (iii) gross internal rate of return and gross multiple of invested capital for both the realized and unrealized portions shown separately. The quarterly report for Illiquid funds would include fund performance measures since inception through the end of the current calendar quarter. The performance measures would also be calculated without the impact of any fund-level subscription facilities as defined in the rule. Advisers would also be required to provide investors with a statement of contributions and distributions reflecting the aggregate cash inflows from investors and the aggregate cash outflows from the fund to investors along with the fund’s net asset value.
Prominent Disclosure of Performance Calculation Information. The rule would also require advisers to include prominent disclosure of the criteria used and assumptions made in calculating the performance as part of the quarterly statement and not as part of a separate document, website hyperlink or QR code or other separate disclosure.
- Distribution of Quarterly Statements
Account statements would be required to be distributed by advisers to fund investors within 45 days after each calendar quarter end. The proposed rule would allow the adviser to distribute a quarterly statement for a newly formed private fund after the fund’s second full calendar quarter generating operating results. In scenarios where the investor is a pooled investment vehicle that is in a “control relationship” with the adviser or its related persons, the adviser must look through that pool (and any pools in a control relationship with the adviser or its related persons) to distribute the quarterly statement to investors in those pools.
- Consolidated Reporting for Certain Fund Structures
In certain circumstances, the rule would allow advisers to consolidate reporting for substantially similar pools of assets to the extent doing so would provide more meaningful information to the private fund’s investors and would not be misleading.
Advisers would be required to retain books and records related to this rule. Specifically, advisers would be required to (1) retain a copy of any quarterly statement distributed to fund investors; (2) retain all records evidencing the “calculation method for all expenses, payments, allocations, rebates, offsets, waivers, and performance” disclosed in any quarterly statement; and (3) retain records that substantiate the determination of whether the private fund managed is a liquid fund or an illiquid fund.
2. Private Fund Audit Rule
A registered private fund adviser would be required to cause the private funds it advises to undergo a financial statement audit by an independent public accountant in accordance or in reconciliation with U.S. GAAP at least annually and upon liquidation. The proposal would require the audited financial statements to be distributed to investors “promptly” after the completion of the audit. The adviser would be required to enter into, or cause the private fund to enter into, a written agreement with the independent public accountant performing the audit and to notify the SEC upon certain events. For advisers that are not in a “control relationship” with the private funds they manage, the rule would require that such advisers take all reasonable steps to cause its private fund clients to undergo an audit that would satisfy the rule.
Advisers would also be required to keep a copy of any audited financial statements, including related information such as corresponding date(s) sent and delivery method(s). Moreover, the adviser would be required to keep a record documenting steps taken by the adviser to “cause a private fund client with which it is not in a control relationship” to undertake a financial statement audit that would comply with the rule.
3. Adviser-Led Secondaries Rule
Where an adviser or its related persons offers private fund investors the option to sell all or some of their interests in a private fund, or to convert or exchange all or some of their interests for new interests in another vehicle advised by the adviser, the proposed rule would require that the adviser obtain a fairness opinion by an independent opinion provider in connection with such adviser-led secondary transaction. The adviser must also prepare and distribute to the private fund investors a summary of any material business relationships the adviser or any of its related persons has, or has had, within the past two years with the independent opinion provider.
Advisers would also be required to retain books and records to support their compliance. In particular, the adviser would be required to include a copy of the fairness opinion and material business relationship summary distributed to investors, as well as a record of “each addressee, the date(s) the opinion was sent, address(es), and delivery method(s).”
4. Prohibited Activities for All Private Fund Advisers
All private fund advisers, regardless of registration status, and their related persons would be prohibited from “engaging in certain sales practices, conflict of interest, and compensation schemes that are contrary to the public interest and the protections of investors.” These activities would be prohibited regardless of permission granted to the adviser by the private fund’s governing documents and regardless of whether the adviser discloses the practice and private fund investors have consented to the activities either implicitly or explicitly.
- Fees for Unperformed Services
An adviser would be prohibited from receiving compensation for monitoring, servicing, consulting or other fees in respect to any services that the investment adviser does not, or does not reasonably expect to, provide to the portfolio investment. The rule would not prohibit the adviser from receiving payments for services it actually provided or from receiving payments in advance for services it reasonably expects to provide the portfolio investment in the future.
- Certain Fees and Expenses
An adviser would also be prohibited “from charging a private fund for fees or expenses associated with an examination or investigation of the adviser or its related persons by any governmental or regulatory authority,” and regulatory and compliance fees and expenses of the adviser or its related persons, even if such fees and expenses are otherwise disclosed.
- Adviser Clawbacks for Taxes
An adviser would also be prohibited from reducing the amount of any adviser clawback by actual, potential or hypothetical taxes applicable to the adviser, its related persons, or their respective owners or interest holders. “Adviser clawback” is defined broadly to capture individuals and entities that may be allocated or granted performance-based compensation.
- Limiting or Eliminating Liability for Adviser Misconduct
An adviser would also be prohibited from seeking reimbursement, indemnification, exculpation or limitation of its liability by the private fund or its investors for a breach of fiduciary duty, willful misfeasance, bad faith, negligence or recklessness in providing services to the private fund. The proposed rule would prohibit an adviser from seeking indemnification for breaching its fiduciary duty regardless of whether state or other law would permit an adviser to waive its fiduciary duty.
- Certain Non-Pro Rata Fee and Expense Allocations
An adviser would also be prohibited from directly or indirectly charging or allocating fees and expenses related to a portfolio investment (or potential portfolio investment) on a non-pro rata basis when multiple private funds and other clients advised by the adviser or its related persons have invested (or propose to invest) in the same portfolio investment.
An adviser would also be prohibited directly or indirectly from borrowing money, securities or other fund assets, or receiving a loan or an extension of credit, from a private fund client. However, the adviser would be allowed to borrow from a third party on the fund’s behalf and lend to a private fund it manages on terms that do not include excessive interest rates or other abusive practices.
5. Preferential Treatment
All private fund advisers regardless of registration status would be prohibited from granting preferential redemption terms to investors or engaging in selective transparency with current or prospective investors. In addition, advisers would be required to disclose, with specificity, any other favorable terms offered to current or prospective investors. The SEC notes that whether any terms are “preferential” would depend on the facts and circumstances.
- Prohibited Preferential Redemptions
A private fund adviser and its related persons would be prohibited from granting an investor in the private fund or in a substantially similar pool of assets preferential liquidity terms that the adviser reasonably expects to have a material, negative effect on other investors in the private fund or in substantially similar pool of assets. Certain arrangements by some investors to negotiate separate redemption terms — such as allowing them to exit the private fund early and causing the fund to sell liquid assets to accommodate the investors’ redemption — and investment vehicles created to invest alongside the private fund but with more favorable liquidity terms — would be prohibited. An adviser would also be prohibited from granting an investor in substantially similar pools of assets preferential liquidity terms, such as creating another feeder fund with better terms that invests in the same master fund as the original feeder fund used by most investors.
- Prohibited Preferential Transparency
A private fund adviser and its related persons would be prohibited from providing information regarding the portfolio holdings or exposure of the private fund or of substantially similar pool of assets to any investor “if the adviser reasonably believes that providing the information would have a material, negative effect on the other investors in that private fund or in a substantially similar pool of assets.” However, an investor would be allowed to negotiate to receive certain types of information depending on several factors, including the size of its capital commitment or satisfaction of the investor’s internal reporting obligations.
- Other Preferential Treatment
A private fund adviser would be prohibited from providing other preferential terms unless it provides certain written disclosures to prospective and current investors. Moreover, under the proposed rule, the adviser would need to describe specifically the preferential treatment to convey its relevance to the recipient of that disclosure (e.g., provide copies of side letters with redacted information regarding other investors or provide a written summary if it describes the preferential treatment with specificity).
Registered advisers would be required to retain books and records to support their compliance with the preferential treatment rule, including copies of all written notices sent to current and prospective investors in a private fund. Such copies would include a record of each addressee and the corresponding dates sent, addresses and delivery method of each addressee.
6. Compliance Rule Amendments
All SEC-registered advisers would be required to document the annual review of their compliance policies and procedures in writing. The current compliance rule requires advisers to review, no less frequently than annually, the adequacy of their compliance policies and procedures and effectiveness of their implementation — but does not expressly require written documentation. The proposed rules would establish a written documentation requirement for all advisers. Similar to the underlying justification for Rule 38a-1 requiring registered investment companies to produce a written compliance report, the policy goal is to make it easier for SEC examination staff to understand an adviser’s compliance program.
- The proposal is broadly drafted and may create inadvertent consequences for private fund advisers. Advisers should make sure to engage the SEC staff during the comment period because it is likely that the proposal will be significantly modified based on comments that clearly articulate the implications of some of the proposed rules in practice. The public comment period will be open for 30 days after date of publication in the Federal Register or April 11, 2022 (whichever is later).
- Advisers should begin thinking about how they would comply with some of the more difficult parts to implement, including requirements focused on reporting and allocation of fees and expenses — and valuation in support of performance reporting.
- We expect that compliance and financing costs will significantly increase if the proposal is implemented, even in a revised form. Advisers should therefore start thinking about expansions of their compliance and finance departments.
- The proposed rules provide some more firepower for the SEC to pursue examinations and enforcement actions. In anticipation of the final rules and amendments, advisers should get up to speed and start thinking about implementing extensive compliance training programs for their employees to mitigate risk of a bad examination or enforcement outcome.
- The proposal is layered with several carefully drafted definitions that may or may not be in line with industry norms. Advisers should pay close attention to all defined terms in this proposal to prevent any misunderstanding of what would be expected of them if the rule is made final, even in a revised or scaled-down form.