United States: The SEC's New Rules For Private Fund Advisers

On August 23, 2023, the Securities and Exchange Commission (SEC) adopted new rules and amendments under the Investment Advisers Act of 1940 (Advisers Act) to, in its words, "enhance the regulation of private fund advisers" and "to protect private fund investors by increasing transparency, competition, and efficiency in the private funds market." The new private fund advisers rules are not uncontroversial – the SEC adopted the rules by a 3-2 vote, with one of the commissioners characterizing the rules as "ahistorical, unjustified, unlawful, impractical, confusing, and harmful." On September 1, 2023, a group of private equity industry trade groups filed suit in federal court to vacate the rules, asserting that the rules exceed the SEC's statutory authority and violated the requirements for agency rulemaking.

Assuming the rules take effect as the SEC intends, the new requirements apply to advisers to "private funds," which are investment funds that would be investment companies under the federal Investment Company Act of 1940 but for the private investment company exemptions under that act (in other words, virtually all private equity, venture capital, or hedge funds). The rules will impact private fund advisers differently depending on their SEC-registration status and the type and the location of the funds they advise. Certain parts of the new regulations apply to all private fund advisers (including U.S. private fund managers relying on the private fund adviser exemption and fund managers relying on the venture capital fund adviser exemption under the Advisers Act) while other parts apply to only to private fund advisers that are also investment advisers registered with the SEC under the Advisers Act (SEC-registered advisers).

The new rules, which are discussed below, are as follows:

The amendments to the existing rules are as follows:

The new rules and amendments become effective 60 days after publication in the Federal Register, though compliance dates vary depending on the rule and size/registration status of the adviser. Legacy status (grandfathering) is provided for certain aspects of the rules, which are discussed below.

Rules for All Private Fund Advisers

The "restricted activities rule" and the "preferential treatment rule" apply to all private fund advisers, regardless of status as registered investment advisers.

Restricted Activities Rule. The restricted activities rule prohibits private fund advisers from engaging in certain activities and practices, regardless of whether a fund's governing documents permit such activities, unless they satisfy the specific disclosure and consent requirements of the rule. The activities covered include:

• Charging or allocating to the private fund fees or expenses associated with an investigation of the adviser without disclosure to or consent from fund investors. Regardless of any disclosure or consent, the adviser may not charge or allocate fees and expenses related to an investigation resulting in a sanction for violating the Advisers Act or SEC rules;
• Charging or allocating to the private fund any regulatory, compliance, or examination-related fees or expenses unless disclosed to investors;
• Reducing the amount of an adviser clawback by 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;
• Charging or allocating fees and expenses related to a portfolio investment on a non-pro rata basis, unless the allocation approach is fair and equitable and the adviser distributes advance written notice of the non-pro rata charge and a description of how the allocation approach is fair and equitable under the circumstances; and
• Borrowing money, securities, or other private fund assets, or receiving a loan or an extension of credit from a private fund client without disclosure to, and consent from, fund investors.

Preferential Treatment Rule. The preferential treatment rule prohibits all private fund advisers from providing preferential treatment with respect to redemption rights and portfolio holdings or other information that, in each instance, the adviser reasonably expects would have a material, negative effect on other investors in that fund or a similar pool of assets. The rule also requires disclosure of all other types of preferential treatment. The redemption prohibition contains an exception for redemptions required by law or governmental order and does not apply if the private fund adviser offers the same redemption rights to all existing investors and will continue to offer the same rights to all future investors in the private fund or "similar pool of assets." The preferential information rule prohibits a private fund adviser from providing information regarding the portfolio holdings or exposures of the private fund, or of a similar pool of assets, to any investor in the fund if the adviser reasonably expects that providing the information would have a material, negative effect on other investors in that private fund or in a similar pool of assets. The information prohibition does not apply if the private fund adviser offers such information to all other existing investors in the private fund and any similar pool of assets at the same (or substantially the same) time.

The term "similar pool of assets" is generally defined (with certain exceptions) as a pooled investment vehicle with substantially similar investment policies, objectives, or strategies to those of the private fund managed by the investment adviser or its related persons. According to the SEC's adopting release, whether a pool of assets is managed by the private fund adviser is "similar" to the private fund requires a facts and circumstances analysis. A pool of assets with a materially different target return or sector focus, for example, would likely not have substantially similar investment policies, objectives, or strategies to those of the subject private fund "depending on the facts and circumstances." The SEC also noted, however, that the definition was designed to capture most commonly used private fund structures and to prevent advisers from structuring around the prohibitions on preferential treatment.

The preferential treatment rule allows private fund advisers to grant to investors other preferential rights so long as such preferential treatment is adequately disclosed in a written notice that includes specific information regarding any preferential treatment related to any material economic terms provided to other investors in the same private fund. For prospective investors, such written notice must be provided in advance of investment in the fund. Private fund advisers must provide the notice to current investors as soon as reasonably practicable, for an "illiquid fund" (for example, private equity and venture capital funds) following the end of the fund's fundraising period, and for a "liquid fund" (for example, hedge funds and commingled "long-only" funds) following the investor's investment in the fund. Disclosure must be provided on at least an annual basis thereafter. While not otherwise defining the phrase, the SEC indicated that "material economic terms" include those terms that an investor would find most important and that would significantly impact its bargaining position, such as the cost of investing, liquidity rights, investor-specific fee breaks, and co-investment rights.

Rules for SEC-Registered Private Fund Advisers

In addition to the new and amended rules that apply to all advisers to private funds, the SEC also adopted a set of rules that apply to private fund advisers that are registered with the SEC as investment advisers under the Advisers Act. These rules include:

Quarterly Statement Rule. Registered private fund advisers must prepare and distribute a quarterly statement to private fund investors that discloses fund-level information regarding performance, the cost of investing in the private fund, fees, and expenses paid by the private fund, and certain compensation and other amounts paid to the adviser. In general, the statement must be distributed to investors within 45 days after the end of each of the first three fiscal quarters of each fiscal year and 90 days after the end of each fiscal year. The rule includes general format and content requirements meant to improve legibility and to make comparing funds easier, and the statement must use clear, concise, plain English and be presented in a format that facilitates review from one quarterly statement to the next.

Private Fund Audit Rule. Registered private fund advisers must obtain an annual financial statement audit of each covered private fund that they advise. The audit must meet the requirements of the audit provision in the SEC's custody rule under the Advisers Act (rule 206(4)-2)). Among other standards, this would require that the audit be conducted in accordance with Public Company Accounting Oversight Board (PCAOB) or U.S. generally accepted auditing standards by an independent public accountant registered with the PCAOB and distributed to investors within 120 days of fiscal year-end.

Adviser-Led Secondaries Rule. An "adviser-led secondary transaction" is any transaction initiated by the registered private fund adviser or any of its related persons that offers investors in the private fund the choice between selling all or a portion of their interests in the private fund and converting or exchanging 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. In such an adviser-led transaction, the registered private fund adviser must obtain and distribute to its investors a fairness opinion or written valuation opinion, as well as a summary of any material business relationships between the adviser and the independent opinion provider within the last two years preceding the issuance of the fairness or valuation opinion.

Books and Records Rule Amendments. The SEC amended its books and records rule under the Advisers Act for registered private fund advisers to facilitate the SEC's ability to assess an adviser's compliance with the rules.

Documentation of Annual Compliance Policy Review

In connection with the general private fund advisers rule, the SEC also amended its rule that requires all advisers (whether or not they advise private funds) to review, at least annually, the adequacy of their compliance policies and procedures and the effectiveness of their implementation. The SEC stated that the annual review requirement was intended to require advisers to evaluate periodically whether their compliance policies and procedures continue to work as designed and whether changes are needed to assure their continued effectiveness. The amended rule adds a new requirement that the annual review be documented in writing. The amended rule does not establish specific elements that advisers must include in the written documentation nor does it prescribe a specific format of the written documentation.

Compliance Dates and Legacy Status

The new and amended rules will take effect in November 2023; however, the SEC has extended the compliance dates and provided for legacy status for certain aspects of the rules, as follows:

• For the audit rule and quarterly statement requirement (applicable to SEC-registered investment advisers), 18 months after publication in the Federal Register.
• For the adviser-led secondaries rule, the preferential treatment rule and the restricted activities rule:
  • 12 months after publication in the Federal Register for advisers with $1.5 billion or more in private funds assets under management; and
  • 18 months after publication in the Federal Register for advisers with less than $1.5 billion in private funds assets under management.
• For the amended Advisers Act compliance rule, 60 days after publication in the Federal Register.

The SEC also provided legacy status for the portion of the preferential treatment rule that prohibits certain redemption and information rights and the portion of the restricted activities rule applicable to adviser borrowing from a fund and an adviser charging investigation fees and expenses to a fund. With legacy status, the new rules do not apply to private fund governing agreements where the fund has commenced operations as of the compliance date (described above), the governing agreements (which would include limited partnership agreements, subscription agreements and side letters) were entered into prior to the compliance date, and the portion of the rules would otherwise require the parties to amend such governing agreements.

A copy of the SEC's 660-page rulemaking is available here.

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.