SEC Adopts Significant New Changes for Private Fund Advisers

At a Glance

• The U.S. Securities and Exchange Commission (SEC) recently approved new rules under the Investment Advisers Act of 1940 which will have a significant impact on private fund advisers.
• These rules will require private fund advisers to distribute quarterly statements to investors; distribute audited financials annually to investors; distribute a fairness opinion or valuation opinion for adviser-led secondaries; refrain from restricted activities with the private fund; and disclose to all investors any preferential treatment granted to certain investors.
• The SEC said the new rules were adopted to protect private fund investors by deterring fraud, deception and manipulative practices by private fund advisers, although the new rules will also impose significant compliance, operations and regulatory burdens on all private fund advisers.

This alert was updated November 1, 2023.

On August 23, 2023, by a vote of three-to-two, the U.S. Securities and Exchange Commission (SEC) approved changes under the Investment Advisers Act of 1940 (the Advisers Act) that will substantially impact private fund advisers. The SEC noted that the new rules (collectively, the New Rules) are intended to protect private fund investors, given that private fund advisers’ assets under management have significantly increased to over $22.6 trillion for all types of investors, including retirement systems and indirectly their beneficiaries. The SEC noted that the New Rules are intended to increase transparency, improve governance mechanisms, and address conflicts of interest of private fund advisory practices. Even with the SEC’s position that the New Rules will deter fraud, deception or manipulative practices with respect to pooled investment vehicles, the New Rules will place significant compliance burdens on private funds and their advisers. This article summarizes the compliance, operations and regulatory obligations imposed by New Rules on private fund advisers, including compliance deadlines.

The New Rules consist of five major obligations that will require private fund advisers to:

1. Distribute quarterly statements to investors.
2. Distribute annual financials audits to investors.
3. Distribute a fairness opinion or valuation opinion for adviser-led secondaries.
4. Refrain from engaging in restricted activities with the private fund.
5. Disclose materials terms of certain preferential treatment of private fund investors.

The New Rules apply to advisers to private funds – i.e., pooled investment vehicles that would be subject to registration as an “investment company” but for reliance on an exemption from registration under Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act. The quarterly statements, audit and adviser-led secondaries requirements apply to all advisers that are (or should be) registered with the SEC under the Advisers Act (RIAs). The restricted activities and preferential treatment requirements apply to all private fund advisers irrespective of registration status, including state-registered investment advisers and those that are exempt from registration (collectively referred to as Private Fund Advisers).

Quarterly Statements

Under New Rule 211(h)(1)-2 (the Quarterly Statement Rule), RIAs must distribute quarterly statements to private fund investors within 45 days after the end of the first three fiscal quarters and within 90 days after the end of the fiscal year (or within 75 and 120 days, respectively, for a funds of funds). Quarterly statements must include:

• “Fund Expenses Table” that includes detailed accounting of all compensation, fees and expenses, and other amounts allocated or paid by the private fund, and any fee offsets or rebates carried forward during the reporting period.
• “Portfolio Investment Table” that reflects all compensation to a Private Fund Adviser that is paid by, or allocated to, each covered portfolio investment.
• Disclosure regarding the calculation methodology of all fees and expenses including cross references to the fund’s organizational and offering documents that permit the payment of such fees and expenses.
• Standardized performance information, which will vary depending on whether fund is “liquid” or “illiquid” as follows:
  • Liquid funds must include annual net returns for each year over the past 10 fiscal years or since inception, average annual net total returns for one-, five-, and 10- fiscal year periods, and cumulative net total return for the current fiscal year through the quarter covered by the statement.
  • Illiquid funds must include inception-to-date gross and net IRR, gross and net MOIC, gross IRR and MOIC of realized and unrealized extracts of the portfolio, and a statement of contributions and distributions.

Additional recordkeeping requirements. RIAs will be required to retain quarterly statements, as well as names of all addressees and dates sent; records evidencing the calculation method for all expenses, payments, allocation, rebates, offsets, waivers and performance listed in delivered quarterly statements; and books and records substantiating the RIA’s determination that a private fund is liquid or illiquid.

Mandatory Audit Rule

Under New Rule 206(4)-10 (the Mandatory Audit Rule), RIAs are required to cause the private funds they manage to undergo financial statements audits and deliver the audited financial statements to fund investors. The Mandatory Audit Rule “effectively eliminate[s] the surprise examination option for these RIAs under the custody rule (Rule 206(4)-2 of the Advisers Act). Accordingly, RIAs will be required to ensure that its private fund clients’ financial statements are: (i) prepared in accordance with (or reconciled to) U.S. GAAP; (ii) audited on an annual basis by an independent registered public accounting firm that is registered with the Public Company Accounting Oversight Board (PCAOB); and (iii) distributed to all fund investors within 120 calendar days of the fund’s fiscal year end (or 180 days for any fund of funds). Private funds also will be subject to audit requirements in the event of liquidation. This Rule applies to a private fund client even if the RIA would not be deemed to have custody of the client’s assets.

Exceptions to the Mandatory Audit Rule:

• The Mandatory Audit Rule does not apply to Exempt Reporting Advisers (e.g., private advisers exempt from registration under the Adviser's Act, such as venture capital fund advisers and advisers to solely private funds with less than $150M in assets) (although we note that some states require mandatory audits of private funds managed by Exempt Reporting Advisers).
• The Mandatory Audit Rule also does not apply to offshore private funds managed by non-U.S. offshore advisers with no place of business in the United States.
• If an RIA does not control the private fund (directly or indirectly through an affiliate or related person) and the RIA is neither controlled by nor under common control with the private fund, the RIA only needs to take “all reasonable steps” to cause the private fund client to undergo a financial statement audit. Whether the “all reasonable steps” standard is met will be based on facts and circumstances.

Applicability to special purpose vehicles. When adopting the Mandatory Audit Rule, the SEC’s release reaffirms previous guidance provided with respect to the Custody Rule’s application to private funds and special purpose vehicles (SPVs). Specifically, the SEC noted that an SPV treated as a separate client would be subject to a mandatory annual audit, while an SPVs treated as an “asset” of a private fund would be included in the scope of the fund’s annual audit, and a separate audit of the SPV would not be required under the Mandatory Audit Rule

Reconciliation to U.S. GAAP requirement. The adopting release also reaffirms previous SEC staff guidance that financial statements prepared in accordance with alternative accounting standards similar to U.S. GAAP would comply with the new Mandatory Audit Rule, as long as the financial statements are reconciled to U.S. GAAP.

Additional recordkeeping requirements. RIAs will be required to keep as part of their books and records copies of each private fund’s financial statements, and records of addressees and dates the financial statements were distributed. In addition, to the extent an RIA provides advice to a private fund client it does not control, the investment adviser’s records must document the “reasonable steps” taken to cause the private fund to undergo a financial statement audit.

Adviser-led Secondaries

Under New Rule 211(h)(2)-2 (the Adviser-led Secondaries Rule), an RIA must, prior to the due date of the election form for any Adviser-Led Secondary¹: (1) obtain a written “fairness opinion” or “valuation opinion” from an independent party; (2) distribute the opinion to fund investors; (3) disclose any material business relationship with the opinion provider in the prior two years from the date of the opinion; and (4) maintain a copy of the opinion and material business relationship summary sent to investors, names of addressees and date sent. The person or firm that provides the opinion must be in the business of providing fairness opinions or independent valuations, and the opinion must be current at the time of the transaction. Adviser-led Secondaries exclude tender offers but include sales of publicly traded assets and sales of minority stakes by a private fund.

The SEC noted that the fairness opinion will help investors make information business decisions and will address conflicts of interest inherent in transactions where the adviser to a private fund is on both sides of the transaction. The SEC also stated that requiring a “third party check” will reduce the possibility of investors cashing out at a below market value or potential fraud or deception by an adviser to a private fund.

Additional recordkeeping requirements. In connection with the Advisor-led Secondary Rule, RIAs must make and retain a copy of the fairness opinion or valuation opinion and material business relationship summary distributed to investors, as well as a record of each addressee and the date(s) the opinion and summary were sent.

Restricted Activities

Under New Rule 211(h)(2)-1 (the Restricted Activities Rule), Private Fund Advisers are restricted from engaging in the following practices:

• Charging or allocating to a private fund any expenses associated with an investigation of the Private Fund Adviser by regulatory authorities, absent written consent by majority interest of fund investors that are not related persons of the adviser. However, even if consent is obtained, a Private Fund Adviser may not charge or allocate fees and expenses related to an investigation that results or has resulted in sanctions for violations of the Advisers Act or the rules thereunder.
• Charging or allocating to a private fund any compliance or regulatory expenses associated with an examination of the Private Fund Adviser unless such expenses are disclosed in written notice to investors within 45 days of the end of the fiscal quarter in which the expenses were incurred.
• Reducing any clawback owed to a private fund by the amount of actual (or potential) taxes incurred by the fund’s adviser, general partner or other entity that received carried interest distributions, unless authorized by the fund’s governance documents and the Private Fund Adviser distributes a written notice to investors that includes the aggregate dollar amount of the clawback before and after any reduction for taxes with 45 days after the fiscal quarter in which the clawback occurs.
• Charging fees related to a portfolio or potential portfolio investment on a non-pro rata basis when multiple private funds and other advisory clients of the Private Fund Adviser have invested in the same portfolio investment, unless: (1) the non-pro rata basis method is “fair and equitable” under the circumstances, and (2) in advance of allocating any fees on a non-pro rata basis, the Private Fund Adviser distributes a written notice describing the non-pro rata allocation and how the allocation is fair and equitable.
• Borrowing money, securities or other assets, or taking out a loan or extension of credit, from a private fund, without first: (1) distributing a written notice to fund investors that describes the material terms of the borrowing; (2) seeking investors’ consent; and (3) obtaining consent from at least a majority-in-interest of fund investors unrelated to the adviser.

Additional recordkeeping requirements. In connection with the Restricted Activities Rule, Private Fund Advisers must retain any notification, consent or other documents distributed or received, along with a record of each addressee and the corresponding dates each document was sent.

Legacy status. Under the Restricted Activities Rule, Private Fund Advisers can continue to borrow from private funds and charge the funds for the advisers’ investigation fees and expenses pursuant to the funds’ governing agreement. However, such legacy status does not permit Private Fund Advisers to charge a private fund for fees or expenses related to an investigation that results (or has resulted) in a court or governmental authority imposing a sanction against the adviser for a violation of the Advisers Act or the rules promulgated thereunder.

“Governing agreements” are contractual agreements that (i) govern the fund including but not limited to, operating or organizational agreements, subscription agreements, and side letters and (ii) govern the borrowing, loan, or extension of credit entered into by the fund, which include the agreements set forth in clause (i), as well as promissory notes and credit agreements.

Preferential Treatment Rule (Restrictions on Side Letters)

Under New Rule 211(h)(2)-3 (the Preferential Treatment Rule), Private Fund Advisers are prohibited from offering preferential redemption terms or information access to investors in private funds or a similar pool of assets (other than a securitized asset fund).

1. Preferential redemptions. A Private Fund Adviser cannot allow certain investors to redeem their fund interests under preferential terms if the Private Fund Adviser reasonably expects that such redemptions would have a material, negative effect on other investors; except where the ability to redeem is required by appliable law and such redemption ability is offered to all other existing investors and will continue to be offered to future investors.
2. Selective disclosures. A Private Fund Adviser cannot selectively provide certain investors with information about the fund’s portfolio holdings or exposures if the Private Fund Adviser reasonably expects that providing such information would have a material, negative effect on the other investors; except where such information is offered to other investors at the same (or substantially the same) time.

The reasonably expects standard and the material negative effect standard will be based on facts and circumstances. With respect to information rights, the SEC indicated the standard is more easily triggered when paired with preferential redemption rights. The SEC further indicated that it would not generally view information rights provided to one or more investors in an illiquid fund as having a material, negative effect on other investors.

As noted above, these restrictions will apply to both private funds and investors in a similar pool of assets, defined as any pooled investment vehicle with substantially similar investment policies, objective or strategies of the private fund managed by the investment adviser or its related persons. The term “similar pool of assets” includes different assets pool structures (e.g., limited partnership, limited liability company, master-feeders and parallel funds) as well as different features (e.g., different base currencies or embedded leverage).

With respect to other forms of preferential treatment, Private Fund Advisers are required to provide disclosure and/or notice to investors as follows:

1. Written notice to prospective investors. Private Fund Advisers must provide prospective investors with prior written notice that includes specific information regarding any preferential treatment related to any material economic terms that the Private Fund Adviser (or an affiliate or related person) provides to any investor.

   The SEC stated that a simple statement that, “some investors pay a lower fee” will be insufficient to satisfy the specificity requirement, and that preferential fee terms, including the applicable rate, must be disclosed to all investors.

2. Written notice for current investors. Private Fund Advisers will be required to disclose preferential terms to current investors as follows:
   1. For Illiquid Funds – as soon as reasonably practicable following the end of the fund’s fundraising period, the Private Fund Adviser must provide written disclosure of all preferential terms granted to investors.
   2. For Liquid Funds – as soon as reasonably practicable following an investor’s investment in a private fund, the Private Fund Adviser must provide written disclosure of all preferential treatment provided to investors.
   3. Annual Updates for all Funds – at least annually, the Private Fund Adviser must provide written notice of all preferential treatment the adviser or its affiliates or related persons have provided to investors since the date of the last written notice.

Additional recordkeeping requirements. In connection with the Preferential Treatment Rule, Private Fund Advisers must maintain records including written notices sent to current and prospective investors as well as annual updates, along with names of addressees and the dates that notices were provided. 

Legacy status. The SEC stated that Private Fund Advisers will not be required to “re-paper” existing side letter agreements with investors with respect to private funds that commenced operations before the New Rules’ effective compliance dates. However, the Preferential Treatment Rule only “grandfathers” (e.g., continue to permit) a limited category of activities related to preferential redemptions and the provision of selective information.

It is important to note that Private Fund Advisers may not add parties to an existing side letter after the compliance date in order to grant an additional investor newly prohibited term. To the extent, however, that any newly prohibited terms with legacy status are set forth in the fund’s governing agreement and apply to all investors, an additional investor may be admitted to the fund under those existing terms after the compliance date.   

Guidance on Fiduciary Duty of Private Fund Advisers

Although the New Rules do not include the proposed prohibition on charging a portfolio investment for services the Private Fund Adviser does not (or does not reasonably expect to) provide to the portfolio investment (e.g., monitoring fees, servicing fees, consulting fees, etc.), the SEC stated its belief that these activities are “inconsistent with the Private Fund Adviser adviser’s fiduciary duty.” As a result, Private Fund Advisers can continue to receive payments in advance for services reasonably expected to be provided in the future, so long as any amounts paid in advance but not earned with respect for unperformed services are refunded to the private fund.

The SEC also noted that the New Rules do not include the proposed waiver and indemnification prohibition (seeking reimbursement, indemnification, exculpation or limitation on liability for breach of fiduciary duty, willful misfeasance, bad faith, negligence or recklessness in providing services to the private fund) because of its belief that the proposed prohibition is not needed to address the practice. Rather, the SEC reaffirmed and clarified its view that “a waiver of an adviser’s compliance with the federal antifraud liability for breach of fiduciary duty to the private fund or otherwise, or any other provision of the Adviser Act, or rules thereunder, is invalid under the Act consistent with the SEC’s 2019 Fiduciary Interpretation.²”

Written Annual Compliance Reviews

Final amended rule 206(4)-7(b) requires all RIAs to document their chief compliance officer’s annual review of the effectiveness of the RIA’s compliance policies and procedures, as well as any material compliance matters that occurred during the year, in writing. There are no enumerated elements that RIAs must include in the written documentation of their annual review, nor does the amended rule prescribe a particular format. Rather, the adopting release offers a range of formats that would be acceptable — from a lengthy written report with supporting documentation to a compilation of notes throughout the year. RIAs are required to maintain the written documentation of their annual compliance reviews in an easily accessible place for at least five years after the end of the fiscal year in which the review was conducted, the first two years in an appropriate office of the adviser.

We note that it’s currently standard for the SEC staff to request annual compliance reviews during the review period when conducting adviser examinations. The SEC stated that staff will rely on a RIA’s annual compliance reviews to better understand the overall compliance program and whether required compliance policies and procedures have been implemented and/or are operating effectively. As a result, we recommend that RIAs consult with qualified in-house or external counsel before finalizing their annual compliance reviews.

Applicability, Transition Period and Compliance Dates