Key Takeaways:
- Recently proposed new rules governing investment advisers to
private funds would impose substantial new compliance obligations,
as well as implement prohibitions on several material,
industry-wide practices. - Investment advisers to any private fund, regardless of strategy
and whether registered or exempt, should pay close attention to
developments on these proposals and contact counsel with any
questions. - The comment period on the proposed rule is set to expire on
April 25, 2022.
Overview:
On February 9, 2022, more than a decade after the Dodd-Frank
Wall Street Reform and Consumer Protection Act of 2010 increased
the Securities and Exchange Commission’s (the “SEC”)
oversight of advisers to private funds (pooled investment entities
exempt from registration under either Section 3(c)(1) or Section
3(c)(7) of the Investment Company Act of 1940), the SEC proposed a
series of sweeping amendments to the Investment Advisers Act of
1940 (the “Advisers Act”) aimed at addressing a number of
concerns stated by the Staff regarding private fund transparency
and conflicts of interest. The comment period for the proposed rule
is set to end on April 25, 2022.
The SEC’s proposals would require investment advisers that
are registered under the Advisers Act and managing one or more
private funds to:
- provide investors with quarterly statements detailing
information about private fund performance, fees and expenses; - obtain an annual audit for each private fund it advises and
cause the private fund’s auditor to notify the SEC upon certain
events; and - distribute to investors, in connection with an adviser-led
secondary transaction, a fairness opinion and a written summary of
certain material business relationships between the adviser and the
opinion provider.
In addition, all investment advisers to private funds, whether
or not registered with the SEC, would be prohibited from:
- charging fees or seeking reimbursement for certain activities;
and - providing certain types of preferential treatment to favored
investors and granting other types of preferential treatment
without disclosing such preferential treatment.
The SEC also proposes to require all registered advisers to
document the annual review of their compliance policies and
procedures in writing.
Quarterly Statement Rule:
Registered investment advisers would be required to distribute,
for each private fund that it advises, a quarterly statement to
such private fund’s investors within 45 days after each
calendar quarter end. The statement would include the
following:
- All compensation, fees, and other amounts allocated or paid to
the investment adviser by the fund during the reporting period,
both before and after any offsets, rebates or waivers have been
applied, with a separate line item for each category reflecting the
total dollar amount; - All fees and expenses paid by the private fund, including
organizational, accounting, legal, administration, audit, tax, due
diligence, and travel fees and expenses, during the reporting
period, both before and after any offsets, rebates or waivers have
been applied, with separate line items for each category reflecting
the total dollar amount; and - If applicable, the amount of any offsets or rebates carried
forward during the reporting period to subsequent periods to reduce
future payments or allocations to the adviser. - For each covered portfolio investment:
- All portfolio investment compensation allocated or paid to the
investment adviser by the covered portfolio investment during the
reporting period, with separate line items for each allocation or
payment with the total dollar amount, both before and after the
application of any offsets, rebates or waivers; and - The fund’s ownership percentage of each such covered
portfolio investment as of the end of the reporting period, or, if
the fund does not have an ownership interest, a brief description
of the fund’s investment.
- All portfolio investment compensation allocated or paid to the
Advisers must also include a description of how expenses,
payments, allocations, rebates, waivers and offsets were calculated
and include cross references to the sections of the private
fund’s organizational and offering documents that set forth the
methodology.
In addition, the quarterly statements must also include
information regarding the fund’s performance. Levels of
disclosure will vary depending on a determination by the adviser of
whether the fund is an illiquid fund or a liquid fund. An illiquid
fund is a fund that: (i) has a limited life; (ii) does not
continuously raise capital; (iii) is not required to redeem
interests upon an investor’s request; (iv) has as a predominant
operating strategy the return of the proceeds from disposition of
investments to investors; (v) has limited opportunities, if any,
for investors to withdraw before termination of the fund; and (vi)
does not routinely acquire (directly or indirectly) as part of its
investment strategy market-traded securities and derivative
instruments. As noted in the release, many (but not all) funds that
are venture capital, private equity or real estate pools would be
expected to be illiquid funds. All funds that do not meet the above
criteria will be defined to be liquid funds.
If the adviser determines that the fund is a liquid fund, the
quarterly statements must show annual net total returns for each
calendar year since inception; average annual net total returns
over the one-, five-, and ten- calendar year periods; and the
cumulative net total return for the current calendar year as of the
end of the most recent calendar quarter covered by the quarterly
statement. If the adviser determines that the fund is an illiquid
fund, the quarterly statements must show both the gross and net
internal rate of return and multiple on invested capital. In
addition, the quarterly statements must show the gross internal
rate of return and multiple on invested capital for the realized
and unrealized portions of the portfolio shown separately. The
quarterly statements would also include a statement of
contributions and distributions for the fund, each shown since the
inception of the fund through the end of the quarter covered by the
quarterly statement and computed pro forma without the impact of
any fund-level subscription facilities.
Lastly, quarterly statements will be required to include the
date that the performance information is current through and
prominent disclosure of the criteria used and assumptions made in
calculating the performance.
Private Fund Audit Rule:
The proposed amendments would require registered private fund
advisers to “take all reasonable steps” to cause each
private fund they advise to undergo GAAP (or for certain non-U.S.
managers GAAP equivalent) financial statement audits, performed by
a Public Company Accounting Oversight Board (PCAOB) registered
audit firm that is subject to regular inspection by the PCAOB. Such
audits would be required to occur annually and upon liquidation,
and to be distributed to investors promptly upon completion. As
many private funds have existing audit requirements for purposes of
compliance with the custody rule (Rule 206(4)-5) and investor
requirements, this component of the proposal may be expected to
have minimal impact on many firms, although private fund managers
who previously relied upon delivery of quarterly account statements
by the custodian and an annual surprise examination will be
expected to need to implement changes to comply. In addition,
auditors would have new requirements to undertake, by written
agreement with the private fund manager, to directly notify the SEC
of the issuance of a modified audit opinion and upon the
termination of such auditor’s engagement (or removal from
consideration for reappointment).
Adviser-Led Secondaries Rule:
The proposed rule would also require registered private fund
advisers to obtain a fairness opinion in connection with an
adviser-led secondary. Such opinion would come from an independent
provider who would opine on the fairness of the price being offered
to the private fund for any assets being sold as part of the
transaction. Furthermore, the adviser would also be required to
distribute to its investors a summary of any material business
relationships the independent opinion provider and adviser have had
within the past two years.
Prohibited Activities Rule:
The proposal would prohibit all private fund advisers
(registered and unregistered) from engaging in a number of
activities and practices, including:
- Charging a portfolio investment 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 to the portfolio investment; - Charging the private fund for fees or expenses associated with
a governmental or regulatory examination of the adviser; - Charging the private fund for any regulatory or compliance fees
or expenses of the adviser (provided that certain expenses directly
related to the private fund, such as Section 13 and Section 16
beneficial ownership reporting, may continue to be a fund expense
if so provided by the constituent documents of the private
fund); - 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; - 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 fund; - Charging or allocating fees and expenses related to a portfolio
investment or prospective portfolio investment on a non-pro rata
basis when multiple private funds and other clients advised by the
adviser have invested, or will invest, in the same portfolio
investment; and - Borrowing money, securities or other private fund assets, or
receiving a loan or an extension of credit, from a private fund
client.
Preferential Treatment Rule:
The proposed rule would prohibit an investment adviser from
granting an investor in a private fund, or in an investment vehicle
with substantially similar investment policies, objectives or
strategies (a “substantially similar pool of assets”),
the ability to redeem its interest on terms that the adviser
expects to have a material, negative effect on other investors in
that private fund. Furthermore, an investment adviser could not
provide information regarding the portfolio holdings or exposures
of the private fund to any investor if the adviser expects that
providing the information would have a material, negative effect on
other investors in that private fund, for instance, by allowing
certain investors to front-run others in decisions to buy or sell
interests in the private fund.
In addition, an investment adviser to a private fund would not
be able to provide any other preferential treatment to any investor
in the private fund unless the adviser provides written notice to
each prospective investor in the private fund, prior to the
prospective investor’s investment in the private fund,
regarding any preferential treatment the adviser or its related
persons provides to other investors in the same fund. Investment
advisers would also be required to distribute to current investors,
on at least an annual basis, written disclosure of any preferential
treatment provided by the adviser to other investors in the same
private fund since the last written notice was provided.
It is worth noting, that while the Commission acknowledges that
similar concerns may exist for separately managed accounts running
substantially similar strategies to a private fund, its proposed
rule does not yet extend to such accounts.
Books and Records Rule Amendments:
To ensure compliance with the foregoing proposed rules, the SEC
has also proposed to amend the books and records rule under the
Advisers Act in order to require advisers to retain records related
to the proposed rules.
Solicitation of Further Comments:
In addition to comments on the amendments summarized above, in
the proposing release the SEC seeks comments and has requested
input on several additional items that are crucial to the private
fund industry. In particular, the SEC solicits input on the
following questions:
- Whether certain compensation models, notably the “2 and
20” model, should be prohibited; - Whether the SEC should impose limitations on management fees or
require that it be tied to invested capital or net asset value and
prohibit fees on uncalled committed capital; - Whether advisers should be prohibited from presenting
performance with the impact of fund-level subscription
facilities; - Whether a universal template for all private fund quarterly
statements should be imposed; - Whether any of the proposed requirements impose unnecessary
costs or compliance challenges; and - Whether advisers will be able to determine whether a private
fund it manages is a liquid or illiquid fund.
If interested, comments may be submitted on the SEC’s
comment form, which can be accessed here: http://www.sec.gov/rules/submitcomments.htm.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
