New SEC Rules Change Private Fund Regulation

Authored by Debbie Klis with contributions from Nicole Kalajian and Robin Powers.

On August 23, 2023, the Securities and Exchange Commission (“SEC”) issued new final rules that impose significant new requirements on private fund advisers (the “Rules”). [1] The Rules impose limits on awarding preferential rights to certain investors, as well as mandating new disclosure, auditing, and reporting obligations for private fund advisers. [2] The new requirements are detailed below in summary form.

Restricted Activities.  Unless certain new disclosure (and sometimes consent requirements) are satisfied, all private fund advisers [3] are prohibited from the following:

• Charging fees for investigations. Charging or allocating to a private fund fees or expenses associated with an investigation of the adviser without disclosure and consent from fund investors. Further, an adviser may not 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.
• Charging for adviser compliance costs. Charging or allocating to a private fund any fees or expenses associated with regulatory, examination, or compliance by the adviser or its related persons, unless such fees are disclosed to investors.
• Reducing adviser carried interest clawback for taxes. Reducing the amount of any adviser clawback by the amount of actual, potential, or hypothetical taxes applicable to the adviser, its related persons, or their respective owners or interest holders, unless the adviser discloses the pre-tax and post-tax amount of the clawback to investors.
• Non-pro rata allocation of portfolio investment fees among multiple funds or clients. Charging or allocating fees and expenses related to a portfolio investment on a non-pro rata basis when more than one private fund or client advised by the adviser or its related persons have invested in the same portfolio company, unless doing so is fair and equitable and the adviser distributes advance written notice of the non-pro rata charge or allocation and a description of how it is fair and equitable under the circumstances.
• Borrowing. Borrowing money, securities, or other private fund assets, or receiving a loan or extension of credit, from a private fund client, absent disclosure and investor consent.

Financial Statements.  All SEC-registered private fund advisers [4] (and those required to be registered) must provide to investors:

• Annual Audits. Audited annual financial statements within 120 days of the fiscal year-end, and promptly upon liquidation. Audits must be performed by an independent public accountant (subject to regular inspection by the Public Company Accounting Oversight Board (“PCAOB”) and prepared in accordance with U.S. GAAP. [5]
• Quarterly Statements. Quarterly statements within (i) 45 days of the end of each of the first three fiscal quarters, and (ii) 90 days of the end of the fiscal year. [6] The quarterly statements must disclose all fees, expenses, and performance information, must be presented in table format using “clear, concise, plain English”, and may not group expenses into broad categories or label expenses as “miscellaneous.” The quarterly statement must provide cross-references to the relevant sections of the fund’s organizational and offering documents and disclose standard performance metrics.
• Disclosure of performance measures: An adviser of a liquid fund must disclose annual net total returns since inception or for each fiscal year for the 10-year period preceding the quarterly statement, whichever is shorter. An adviser of an illiquid fund must disclose the following performance measures calculated with and without the impact of any fund-level subscription facilities: (i) gross internal rate of return (“IRR”) and gross multiple of invested capital (“MOIC”) [7]; (ii) net IRR and net MOIC; and (iii) gross IRR and gross MOIC for the realized and unrealized positions of the illiquid fund’s portfolio, shown separately.

Preferential Treatment.  All private fund advisers are prohibited from providing certain investors favorable terms [8], as follows:

• Prohibited preferential redemptions. Preferential redemption rights if the adviser reasonably expects that such preferential rights would have a material, negative effect on other investors in the fund or in a “similar pool of assets.” If it would have a material, negative effect on other investors, the adviser must offer the same redemption rights to all investors. An exception to this rule applies if the preferential redemption rights are required by applicable laws, rules, regulations, or orders of any relevant foreign or U.S. government, state, or political subdivision to which the investor, private fund, or any similar pool of assets is subject.
• Prohibited preferred information rights. Preferential information rights regarding the portfolio holdings or exposures of the private fund or a similar pool of assets if the adviser reasonably expects that providing the information would have a material, negative effect [9] on other investors in the private fund or in a similar pool of assets, unless the adviser offers the information to all existing investors at the same, or substantially the same, time.
• Prohibited material preferential economic terms. Preferential material economic terms, unless the adviser provides (i) advance written notice to prospective investors, and (ii) written notice to current investors annually. For this purpose, preferential material economic terms include, in part, costs of investing, liquidity rights, fee breaks, and co-investment rights to the extent that terms materially differ from those of the fund.
• Similar pool of assets. The SEC defined “similar pool of assets” as a pooled investment vehicle with substantially similar investment policies, objectives, or strategies to those of the private fund managed by the adviser or its related persons, which can include, in certain circumstances, a fund of one or single investor fund (other than an investment company registered under the Investment Company Act of 1940 or a company that elects to be regulated as such and not SAFs or separately managed accounts). The definition of “similar pool of assets” [10] is intended to prevent fund advisers from structuring around the preferential treatment prohibitions by, for example, creating parallel funds solely for investors with preferential terms.

Adviser-Led Secondaries. All SEC-registered private fund advisers [11] (and those required to be registered) that offer investors the choice between: (i) selling all or a portion of their interests in the fund and (ii) converting or exchanging all or a portion of their interests in the fund for interests in another vehicle advised by the adviser or any of its related persons must provide to investors:

• Fairness or valuation opinion. A fairness or valuation opinion from an independent opinion provider and distribute the opinion to investors before the due date of an election form.
• Summary of any material business relationship. A written summary of any material business relationships [12] between the adviser or its related persons and the independent opinion provider, within the prior two years.

Compliance.  All SEC-registered advisers (including those that do not advise private funds) must document in writing:

• Annual Compliance Reviews. The annual review of their compliance policies and procedures by November 13, 2023. Advisers have the flexibility to document the results of the annual review in a manner that best fits their business and to use the most effective review procedures.
• Books and records. Compliance with the new Rules and must retain books and records reflecting their compliance.

Rules Implementation Timeline

* Large funds have $1.5 billion or more in private fund assets under management. Small funds have less than $1.5 billion in private fund assets under management.

[1] See Final Rule: Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews (sec.gov).

[2] Applicable private funds are those issuers that would be considered an investment company under the Investment Company Act of 1940, as amended (the “Advisers Act”) but for the exclusions provided under Sections 3(c)(1) or 3(c)(7).

[3] This new requirement applies regardless of whether a private fund adviser is registered, exempt, State registered or State exempt, but excludes securitized asset funds (“SAFs”).

[4] Excluding SAFs.

[5] Where a fund is not controlled or under common control of the adviser (e.g., a fund of funds), the adviser only needs to take “reasonable steps” to cause the private to undergo an audit.

[6] Fund of funds advisers must distribute the quarterly statements within (i) 75 days of the first three fiscal quarters and (ii) 120 days of the end of the fiscal year.

[7] MOIC is defined as (i) the sum of (A) the unrealized value of the illiquid fund; and (B) the value of all distributions made by the illiquid fund; (ii) divided by the total capital contributed to the illiquid fund by its investors.

[8] The new Rules governing preferential treatment are likely to significantly impact the use of side letters.

[9] The SEC acknowledged that it is easier to trigger the material, negative effect in an open-end fund (such as a hedge fund) where certain investors receive preferential information and have the ability to redeem their interests. The SEC noted that it would generally not view preferential information rights provided to one or more investors in a closed-end private fund (such as venture capital and private equity fund) as having a material, negative effect on other investors. However, the SEC did not provide an exemption for all closed-end funds, and thus the determination will require a facts and circumstances analysis.

[10] Included in this term is a variety of pools, regardless of whether they are private funds, including LLCs, partnerships, and other structures, regardless of the number of investors; feeders to the same master fund; parallel fund structures and alternative investment vehicles; pooled vehicles with different base currencies and pooled vehicles with embedded leverage if they have substantially similar investment policies, objectives, or strategies as those of the subject private fund.

[11] Excluding SAFs.

[12] Audit, consulting, capital raising, investment banking and other similar services would typically meet the “material business relationship” definition.

Attorney Advertising. This document is not intended to be and is not considered to be legal advice. Transmission of this document is not intended to create, and receipt does not establish an attorney-client relationship. Prior results do not guarantee a similar outcome.

Debbie Klis brings substantial investment fund, securities and capital markets experience with a particular emphasis on private equity and advising investment firms and equity sponsors on all aspects of their business including the formation, marketing and management of investment products, the launching of new business lines, and strategic investments and transactions, as well as the related operational, legal and regulatory issues. Read more here.

Nicole Kalajian is a Chicago-based attorney who focuses her practice on investment management. Ms. Kalajian represents securities and commodities professionals in a variety of regulatory, compliance and corporate matters. She has extensive experience advising private fund clients, including hedge funds, commodity pools, cryptocurrency funds, fund of funds, socially responsible investment vehicles, venture capital funds, private equity funds and real estate funds. Read more here.

Robin Powers advises buy-side and other market participants on a broad range of trading and derivatives documentation and transactions, with a focus on cleared and uncleared derivatives and cross border regulation. She counsels clients with respect to regulatory issues including Dodd Frank and EMIR compliance, clearing and Swap Execution Facility relationships and uncleared swap margin related issues. Read more here.