SEC proposes new rules affecting private fund advisers

On February 9, 2022, the Securities and Exchange Commission (the SEC) proposed new rules under the Investment Advisers Act of 1940 (the Advisers Act), focused on private fund disclosures and sponsor practices.  The SEC’s stated goal is to increase investor protection and transparency. The SEC has proposed a 60-day comment period and the compliance period for implementing the new rules is expected to be one year after publication of the final rules in the Federal Register.

The proposed rules address the following categories of changes:

1. Quarterly reports and standardized performance disclosure: Registered private fund advisers would be required to prepare a quarterly statement that includes certain information regarding fees, expenses and performance and distribute such statements to investors within 45 days after each calendar quarter. The quarterly statements are proposed to include the following disclosures in a table format: (a) compensation to the adviser and its related persons (i.e., management, advisory, sub-advisory and other similar fees and performance-based compensation); (b) fund-level fees and expenses (i.e., accounting, organizational, legal, audit, administration, tax, due diligence and travel, as well as expenses paid to related persons); (c) itemized portfolio-level fees and expenses in a table on separate line items (i.e., management, consulting, origination, servicing, monitoring, administrative, transaction, advisory, closing, disposition and directors compensation) in respect of certain “covered” portfolio investments (as defined in the rule), with imputed costs to the fund calculated based on its ownership percentage in respect of the relevant portfolio investment; and (d) standardized fund performance information, computed without the impact of any amounts drawn-down on fund-level subscription facilities. Registered private fund advisers would also be required to include disclosures in their fund documents detailing the criteria used and assumptions made in calculating performance-based compensation. The proposed rule cites the ILPA Fee Template, indicating that the quarterly disclosures would need to include “adequate disclosures to investors” akin to those in the template, such that sponsors that currently employ the template (or a similar form) in preparing their reporting may not be subject to undue burden in implementing the new disclosure.
2. Mandatory fund audit: Registered private fund advisers would be required to undergo a financial statements audit in accordance with GAAP, by an independent public accountant of each advised private fund at least annually and upon liquidation. The advisers must notify the SEC if the auditor has resigned or has been terminated or if the auditor has issued a modified opinion. Although the proposed audit rule is based on the custody rule and many private fund advisers already comply with the audit requirement, the new proposed rule differs from the custody rule as follows: (a) there is no exception for compliance with the new audit rule upon the completion of a surprise examination, (b) the new audit rule requires a written agreement between the adviser or the private fund and the auditor such that the auditor would be required to notify the SEC upon the auditor’s termination or the issuance of a modified opinion and (c) the audited financial statements must be distributed to current investors promptly after the completion of the audit as opposed to 120 days after the private fund’s fiscal year-end under the custody rule.
3. GP-led secondaries: Registered private fund advisers would be required to obtain a fairness opinion in connection with any GP-led secondary transaction where the adviser offers fund investors the option to sell their interests in the private fund or exchange them for interests in another vehicle advised by the adviser. As most sponsors already obtain and provide fairness opinions in connection with GP-led secondary transactions, it is not expected that the proposed rule would create an unusual burden to private fund sponsors.
4. Prohibited activities: All private fund advisers (including unregistered private fund advisers such as exempt reporting advisers) or their related persons would be prohibited from conducting the following activities regardless of whether the private fund’s governing documents permit such activities or the adviser otherwise discloses the practices and regardless of whether the fund’s investors have consented to such activities. The proposed rule seems to suggest that the prohibited activities would not apply to registered offshore adviser’s private funds organized outside of the U.S., regardless of whether the private funds have U.S. investors.
   1. Fees for unperformed services: Advisers and their related persons would be prohibited from receiving compensation for monitoring, servicing, consulting, or other fees in respect of any services that the investment adviser does not, or does not reasonably expect to, provide, including accelerated monitoring fees. This rule is mostly focused on accelerating monitoring fees but could have other consequences.
   2. Compliance costs: Advisers and their related persons would be prohibited from charging a private fund for fees and expenses associated with the examination or investigation of the adviser or its related persons by any governmental authority, including compliance expenses. The proposed rule clarifies that regulatory compliance expenses related to the fund, such as Form D filings, can be charged to the fund.
   3. Clawback obligations: Advisers and their related persons would be prohibited from reducing the amount of any adviser clawback by actual, potential, or hypothetical taxes.
   4. Limits to fund indemnification: Advisers and their related persons would be prohibited from seeking reimbursement, indemnification, exculpation or limitation of liability from a private fund or its investors for a breach of fiduciary duty, willful malfeasance, bad faith, negligence or recklessness in providing services to the private fund.
   5. Non pro rata allocation: Advisers and their related persons would be prohibited from charging or allocating fees and expenses related to a 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 in the same portfolio investment. This prohibition would mandate that an adviser allocate co-investment vehicles their pro rata share of broken deal expenses.
   6. Borrowings: Advisers and their related persons would be prohibited from borrowing money, securities or other fund assets or receiving a loan or an extension of credit from a private fund that they manage.
5. Preferential treatment:
   1. Liquidity and portfolio holding information: All private fund advisers (including unregistered advisers) would be prohibited from providing preferential treatment to investors regarding redemptions or information about portfolio holdings or exposures if there is a reasonable expectation that such provisions could have a negative impact on other pools of assets (i.e., pooled investment vehicles with substantially similar investment objectives or strategies managed by the adviser). This proposal does not apply to separately managed accounts.
   2. All other preferential treatments: The SEC also proposes to prohibit investment advisers (including unregistered advisers) from providing any other type of preferential treatment to investors unless the adviser discloses such treatment to other current and prospective investors. The SEC uses excuse provisions as an example. In addition, the SEC describes that merely disclosing that some investors pay lower fees would not be sufficient. Instead, the adviser must describe the lower fee terms, including the applicable rate. Such disclosure can be provided to investors by sending copies of side letters or preparing a separate disclosure.
6. Written annual review: The proposed rules would amend (i) the Advisers Act books and records rule to require advisers to retain books and records related to the proposed quarterly statement rule and (ii) the Advisers Act compliance rule to require all registered advisers to document the annual review of their compliance policies and procedures in writing.

We will continue monitoring the effect of the newly proposed SEC rules and will keep you appraised of any further developments.

To discuss these issues, please contact the author(s).

This publication is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.

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