SEC Proposes Changes to Private Fund Rules

The Securities and Exchange Commission (SEC) recently proposed new rules under the Investment Advisers Act of 1940 (Advisers Act) that would fundamentally alter the disclosure and compliance obligations to which private fund advisers are currently subject. We summarize the proposed rules below, and the full SEC release and proposed rules can be found here.

New Quarterly Statements Requirement

Currently, while some private fund advisers may provide periodic statements to their private fund investors, there is no regulatory requirement to do so. With the stated goal of increasing transparency to investors in private funds, the SEC has proposed a set of new, standardized disclosures that SEC-registered private fund advisers must provide to investors in quarterly statements. These quarterly statements will be required to be provided within 45 days following each calendar quarter end. The information that must be set forth in these quarterly statements is as follows: 

Detailed Accounting of All Fees and Expenses Paid by the Private Fund

Private fund advisers would be required to include on these quarterly statements:

• a detailed accounting of all compensation, fees and other amounts allocated or paid to the adviser or any of its related persons^[1] by the private fund during the reporting period (including fees paid by underlying portfolio investments);
• a detailed accounting of all fees and expenses not included in the bullet above (such as accounting, legal, audit, tax, due diligence and travel expenses reflected as separate line items on the statement); and
• any offsets or rebates carried forward during the reporting period to reduce future payments or allocations to the adviser or its related persons.

Advisers would also be obligated to provide a table of covered portfolio investments^[2] setting forth a detailed accounting of all portfolio investment compensation^[3] allocated or paid by each portfolio investment during the covered period, as well as the private fund’s ownership percentage of each portfolio investment (or if none, a description of the portfolio investment). Advisers would also have to prominently disclose how any expenses, payments, allocations, rebates, waivers and the like are calculated, cross-referencing any relevant sections of the private fund’s organizational and offering documents that set forth the calculations.

Standardized Performance Disclosures

The quarterly statements would also be required to include standardized performance metrics with respect to the applicable private fund. Each statement would need to include prominent disclosure of the criteria used and assumptions made when calculating these performance metrics. The exact information required to be disclosed would depend on whether the fund is defined as a liquid fund or an illiquid fund under the proposed rules. “Illiquid funds” would be defined as private funds that:

• have a limited life;
• do not continuously raise capital;
• are not required to redeem interests upon an investor’s request;
• have as a predominant operating strategy the return of the proceeds from disposition of investments to investors;
• have limited opportunities for investors to withdraw before termination of the fund; and
• do not routinely acquire as part of their investment strategy market-traded securities or derivative instruments.

Advisers to illiquid funds would be obligated to include in each quarterly statement the following performance metrics with respect to the applicable illiquid fund:

• its gross and net internal rate of return and gross and net multiple of invested capital from the fund’s inception through the end of the current calendar quarter; and
• the fund’s gross internal rate of return and gross multiple of invested capital for the realized and unrealized portions of the illiquid fund’s portfolio, with the realized and unrealized performance set forth separately.

Importantly, advisers to illiquid funds must calculate these performance figures without the impact of fund-level subscription facilities.^[4] Essentially, this will require the adviser to the illiquid fund to calculate the performance measures as if the illiquid fund had called investor capital, as opposed to drawing down on any fund-level subscription facilities. In addition, any statement associated with an illiquid fund must include a summary of all contributions and distributions for the private fund. 

“Liquid funds” would be defined as any private funds that are not illiquid funds. Advisers to liquid funds would be required to disclose the applicable liquid fund’s (i) performance based on its net total return on an annual basis since the fund’s inception, (ii) average annual net total returns over one, five and ten years, and (iii) cumulative net total return for the current calendar year as of the most recent calendar quarter.

Required Audits and Auditor Notification to the SEC

The SEC is also proposing that SEC-registered advisers be required to take all reasonable steps^[5] to obtain an annual audit and liquidation audit of the financial statements of the private funds they advise. The requirements associated with the proposed audit rule are very similar to those set forth in the audit requirement of the Advisers Act custody rule. However, unlike the custody rule, the proposed audit rule would prohibit advisers from satisfying the rule by obtaining a surprise examination in lieu of obtaining an audit. Under the proposed rule, audited financial statements generally would need to be prepared in accordance with U.S. Generally Accepted Accounting Principles and would have to be promptly distributed to investors. Furthermore, the written engagement agreement with the private fund auditor would have to obligate the auditor to notify the SEC (i) within four business days of its resignation or dismissal from, or other termination of, its engagement, or upon removing itself or being removed from consideration for being reappointed, and (ii) promptly upon issuing an audit report to the private fund that contains a modified opinion. The auditor would have to be an independent public accountant that meets certain standards of independence and registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board.

Adviser-Led Secondary Transaction Rule

The SEC is further proposing a rule that would prohibit an SEC-registered adviser from completing an adviser-led secondary transaction^[6] with respect to any private fund, unless the adviser distributes to the fund’s investors, prior to the closing of the transaction, (i) a fairness opinion from an independent opinion provider^[7] to alleviate conflict concerns and (ii) a summary of any material business relationships the adviser (or any of its related persons) has had with the independent opinion provider within the past two years.

Prohibitions on Certain Activities

The SEC is also proposing a ban on certain activities by all advisers to private funds (whether or not registered) that it deems contrary to the public interest and the protection of investors. These activities would be prohibited even if the private fund’s governing documents permit them, the adviser otherwise discloses the practices to investors or investors have expressly consented to them.

The prohibited activities include:

• charging a private fund or its portfolio investments fees for underperformed services (e.g., accelerated monitoring fees);
• charging a private fund fees or expenses associated with an examination or investigation of the adviser, or regulatory and compliance fees and expenses of the adviser or its related persons;
• reducing the amount of an adviser clawback^[8] by the amount of taxes paid by the recipients of the applicable performance-based compensation;
• seeking reimbursement, indemnification, exculpation or limitation of its liability for breach of fiduciary duty (regardless of whether applicable state law would permit a waiver of fiduciary duty), willful misfeasance, bad faith, negligence or recklessness in connection with its services to the private fund;
• charging a private fund fees or expenses related to a portfolio investment (including fees and expenses related to consummated and unconsummated investments such as broken deal fees) on a non-pro rata basis across the adviser’s various funds or other advisory clients that have invested in the same portfolio investment;^[9] and
• borrowing money, securities or other fund assets, or receiving an extension of credit from a private fund client.

No Preferential Treatment

The SEC is further proposing prohibiting all private fund advisers (whether or not registered) and their related persons from granting certain preferential treatment to any of their private fund investors. Private fund advisers would be prohibited from granting an investor in the private fund the ability to redeem its interests on terms that the adviser reasonably expects to have a material, negative effect on other investors in the fund. In addition, private fund advisers would be prohibited from providing information regarding portfolio holdings or exposures of the fund to any investor if the adviser reasonably expects that such information sharing would have a material, negative effect on other investors in the fund. Finally, the proposed rule would also prohibit other preferential terms unless the adviser provides written disclosures to prospective and current investors. The preferential terms would need to be described specifically to convey their relevance. These disclosures would have to be provided to prospective investors prior to their investment and annually distributed to existing investors.  

Annual Review of Compliance Policies and Procedures

Finally, the SEC is proposing to amend the Advisers Act compliance rules to require SEC-registered advisers to document the annual review of their compliance policies and procedures in writing. Currently, the Advisers Act does not expressly require written documentation, but the SEC examination staff rely on documentation of the annual review to evaluate whether an adviser is complying with the rules and to identify weaknesses in the adviser’s compliance program. The proposed rule does not list specific items that advisers would be required to include in the written documentation and is intended to be flexible. The written documentation would have to be made available to the SEC promptly upon request.

The comment period will be open for 30 days after the date of publication of the proposed rules in the Federal Register or April 11, 2022, whichever is later. Given the extensiveness of the changes set forth in these proposed rules, the SEC is proposing to provide advisers a one-year transition period to come into compliance with these rules, if they are adopted.

^[1] _{The SEC is proposing to define “related persons” for purposes of this rule as (i) all officers, partners or directors (or any person performing similar functions) of the adviser, (ii) all persons directly or indirectly controlling or controlled by the adviser, (iii) all current employees (other than employees performing only clerical, administrative, support or similar functions) of the adviser, and (iv) any person under common control with the adviser.}

^[2] _{“Covered portfolio investments” would be defined as portfolio investments that allocated or paid the investment adviser or its related persons portfolio investment compensation during the reporting period.}

^[3] _{“Portfolio investment compensation” would be defined as any compensation, fees and other amounts allocated or paid to the investment adviser or any of its related persons by the portfolio investment attributable to the private fund’s interest in such portfolio investment.}

^[4] _{“Fund-level subscription facilities” would be defined as any subscription facility, subscription line financing, capital call facility, capital commitment facility, bridge line or other indebtedness incurred by the private fund that is secured by the unfunded capital commitments of the private fund’s investors.}

^[5] _{This standard is meant to provide flexibility to advisers, as the SEC recognized in its proposal that some advisers may not have the requisite control over private fund clients to cause its financial statements to undergo an audit.}

^[6] _{The SEC has proposed defining “adviser-led secondaries” as transactions initiated by the investment adviser or any of its related persons that offer the private fund’s investors the choice to (i) sell all or a portion of their interests in the private fund or (ii) convert or exchange all or a portion of their interests in the private fund for interests in another vehicle advised by the adviser or any of its related persons.}

^[7] _{An “independent opinion provider” is one that (i) provides fairness opinions in the ordinary course of its business and (ii) is not a related person of the adviser.}

^[8] _{An adviser “clawback” would include any obligation of the adviser, its related persons, or their respective owners or interest holders to restore or otherwise return performance-based compensation to the private fund pursuant to the private fund’s governing agreements.}

^[9] _{It should be noted that the proposed rule does not include an exception for omitting co-investment vehicles or other co-investors from fee and expense allocation related to dead deals.}