On August 23, 2023, the U.S. Securities and Exchange Commission (SEC) adopted new rules and amendments under the Investment Advisers Act of 1940. Although they have been watered down significantly from the version initially proposed in February 2022, the final rules still impose many new requirements and obligations on private fund advisers (aka fund managers), including those who are not RIAs. Once the final rules go into effect 60 days after publication in the Federal Register, they will represent the most significant changes in the SEC’s regulation of private funds and their advisers in over a decade.
New Rules Applicable to All Private Fund Advisers (including those who are not RIAs)
All private fund advisers, regardless of whether they are registered investment advisers (RIAs) or are exempt from registration (such as exempt VC fund managers), will have to comply with the following new rules:
- Preferential Treatment Rule: The Final Rules closely scrutinize any preferential treatment provided to particular investors. The disclosures and prohibitions required by this rule will fundamentally change the side letter process for private funds.
- Notice of Material Economic Terms: Before a prospective investor invests in a fund, the adviser must disclose to that investor any preferential material economic terms already given to current investors.
- Notice of Other Preferential Terms: An adviser must disclose to all current fund investors any preferential treatment the adviser or its related persons grant to other investors in the fund. For illiquid funds (such as typical VC or PE funds), the adviser must provide this disclosure to current investors as soon as reasonably practicable after the end of the fund’s fundraising period. For liquid funds (such as typical hedge funds), the adviser must provide this disclosure to an investor as soon as reasonably practicable following the investor’s investment in the fund. In each case, on an annual basis, the adviser must disclose any new preferential treatment granted since the prior disclosure.
- Prohibitions of Certain Other Preferential Terms: The new rules prohibit private fund advisers from granting two types of preferential treatment to fund investors:
- (i) First, the adviser may not grant redemption rights that the adviser reasonably expects to have a material, negative effect on the other investors in the applicable fund or in a substantially similar pool of assets. There are two exceptions to this—namely for redemption rights required by applicable law, or if they are offered to all existing and future investors in the same fund or pool of assets without qualification.
- (ii) Second, the adviser may not grant to an investor certain preferential information rights about portfolio holdings or exposures of a private fund or substantially similar pool of assets when the adviser reasonably expects that providing such information would have a material, negative effect on the other investors, unless such information is provided to all other existing investors in the fund or pool of assets at the same time or substantially the same time. While the SEC noted that such material, negative effect on the other investors would be more readily discernible in liquid funds that offer redemption rights (rather than illiquid funds), the SEC refrained from limiting this prohibition only to liquid funds.
- Restricted Activities Rule: The SEC will now prohibit certain activities that it has flagged as involving material conflicts of interest. Under the new rules, a private fund adviser may not:
- (i) reduce the amount of the adviser’s clawback obligation by actual, potential or hypothetical taxes, unless the adviser discloses the pre-tax and post-tax amount of the clawback to all investors within 45 days after the end of the fiscal quarter in which such clawback occurs;
- (ii) charge the fund any regulatory, examination or compliance fees or expenses of the adviser, unless the adviser discloses such fees and expenses to all investors within 45 days after the end of the fiscal quarter in which such charge occurs;
- (iii) allocate any fees or expenses associated with portfolio investments on a non–pro rata basis across different funds investing in the same investment, unless the adviser provides advance written notice to all investors, along with an explanation as to why such non–pro rata allocation approach is fair and equitable;
- (iv) borrow directly or indirectly from any private fund client, unless the adviser discloses such borrowing to all investors and obtains consent of a majority-in-interest of the investors; or
- (v) charge any fees or expenses associated with a regulatory investigation of the adviser, unless the adviser discloses such fees and expenses to all investors and obtains the consent of a majority-in-interest of the investors; however, under no circumstances may an adviser charge or allocate to a private fund any fees related to sanctions of the adviser for violation of any rules under the Advisers Act.
- Compliance Date: The transition period for compliance with the new rules described above will be: (1) for advisers with less than $1.5 billion in private fund assets under management, 18 months after the effective date and (2) for advisers with $1.5 billion or more in private fund assets under management, 12 months after the effective date. However, the SEC has granted legacy status to existing private funds with respect to the prohibitions under the preferential treatment rule (described in “Prohibitions of Certain Other Preferential Terms” above) and certain restricted activities that would require investor consent (clauses (iv)-(v) in “Restricted Activities Rule” above), meaning the SEC will not require governing agreements (including side letters) that were entered into prior to the compliance date to be amended.
New Rules Applicable Only to RIAs
- Quarterly Statement Rule: RIAs must provide detailed quarterly statements to all investors with certain disclosures:
- Fees and Expenses Disclosure: These quarterly statements must include, in table format, (1) a detailed accounting of all compensation and fees allocated or paid to the adviser or any of its related persons by the private fund during the reporting period, (2) a detailed accounting of all fees and expenses allocated to or paid by the private fund during the reporting period other than those listed in clause (1) above, and (3) the amount of any offsets or rebates carried forward during the reporting period to subsequent quarterly periods to reduce future payments or allocations to the adviser or its related persons.
- Performance Disclosure: Such quarterly statements must also include standardized fund performance information. With respect to liquid funds, advisers must show performance based on net total return on an annual basis for the 10 fiscal years prior to the quarterly statement or since the fund’s inception, whichever is shorter, over one-, five-, and ten-fiscal year periods. With respect to illiquid funds, advisers must show performance based on internal rates of return and multiples of invested capital since inception, as well as a statement of contributions and distributions. The different categories of performance information must be displayed with equal prominence.
- Compliance Date: RIAs must comply with these rules beginning 18 months after the effective date of the new rules.
- Mandatory Audits: RIAs must obtain annual financial audits for each private fund they manage. RIAs must comply with this rule beginning 18 months after the effective date of the new rules.
- Recordkeeping and Compliance Rule Amendments: RIAs must maintain written documentation of annual reviews of their compliance policies and procedures. The compliance date will be 60 days after the effective date of the new rules.
- Adviser-Led Secondaries Rule: Prior to any adviser-led secondary transaction, RIAs must acquire (and distribute to investors) a third-party fairness or valuation opinion and disclose any material business relationships between the RIA and the opinion provider. The compliance timeline for this rule is the same as those for “Preferential Treatment Rule” and “Restricted Activities Rule” above.
- The SEC has adopted new rules and amendments under the Investment Advisers Act of 1940 that impose several new requirements and obligations on private fund advisers, including those who are not RIAs.
- Under the new rules, among other things, private fund advisers may not: (1) provide preferential treatment to particular investors, such as in side letters, without disclosure to all current and prospective investors or (2) charge certain fees and expenses to their funds or engage in certain other transactions with their funds, without disclosure and/or consent from investors. Additional new rules will require RIAs to provide new regular disclosures, obtain fund audits, engage in additional recordkeeping, and obtain fairness opinions for GP-led secondaries.
- With the exception of certain new rules applicable only to RIAs, the transition period for compliance with the new rules is staggered so that advisers with less than $1.5 billion in private fund assets under management have 18 months until full compliance and advisers with $1.5 billion or more in private fund assets under management have 12 months.