On February 9, 2022, in a 3-1 vote, the U.S. Securities and Exchange Commission (Commission) proposed sweeping changes to allowable practices, reporting, and disclosure aimed primarily at advisers to private funds (i.e., funds relying on the exclusions in Sections 3(c)(1) or (7) of the Investment Company Act of 1940). Despite the title of the proposed rule — “Documentation of Registered Investment Adviser Compliance Reviews” — these proposals extend well beyond compliance reviews and, in fact, well beyond registered investment advisers. If adopted, the proposed rules would affect investment advisers differently depending on their registration status and the type of client the manager advises. Notably, as proposed:
- Various prohibitions on business practices and on “preferential treatment” would apply to all advisers to private funds, not just advisers registered or required to be registered (including both U.S. and non-U.S. exempt reporting advisers (ERAs) and others).
- Amendments requiring annual compliance reviews to be documented in writing also would apply to all registered investment advisers, not just registered advisers to private funds.
- Requirements for quarterly statements, annual audits, and fairness opinions for adviser-led secondaries, however, would apply only to registered private fund advisers and not to ERAs or others.
The requirements of the proposed rules and amendments and the advisers that would be affected by the changes are outlined in the table below.
|Proposed Rule||Advisers Affected|
|All private fund advisers (whether registered or not)|
|Prohibit engaging in certain types of preferential treatment while also prohibiting other types of preferential treatment unless disclosed to current and prospective investors||All private fund advisers (whether registered or not)|
|Provide investors with quarterly statements detailing information about private fund performance, fees and expenses, and adviser compensation||Registered private fund advisers|
|Obtain an annual audit for each private fund and cause the private fund’s auditor to notify the Commission upon certain events||Registered private fund advisers|
|Distribute to investors a fairness opinion and a written summary of certain material business relationships between the adviser and the opinion provider||Registered private fund advisers|
|Document the annual compliance review in writing||All registered advisers|
The proposals represent the most significant modifications to the regulation of private funds since Commission rules requiring private fund advisers to register became effective in 2012. Chairman Gary Gensler has indicated his concerns with and addressed publicly and repeatedly what he views as private fund industry practices that required further regulation to promote investor protection and transparency through several speeches, the Division of Examination’s Risk Alert for private funds, and the Commission’s proposed amendments to Form PF. He expressed his support for the proposed rules and amendments and indicated in his statement his belief that the proposals would “improve the efficiency, competition, and transparency of the activities of private funds’ advisers.” Commissioners Allison Herren Lee and Caroline A. Crenshaw also published statements supporting the proposed rules and amendments.
These proposals, however, are not without controversy. Commissioner Hester Peirce, for example, expressed her strong opposition to the proposed rules, stating that the “proposal represents a sea change” and “a meaningful recasting of the SEC’s mission.” The lone Republican appointee until the other Republican seat is filled, Peirce also noted that resources would be redeployed away from protecting retail investors and that the “application of new prohibitions on private fund advisers that are exempt from registering with us takes another step toward erasing any distinction afforded by the exemption from registration.”
We expect substantial public comments concerning whether the proposed amendments are in the public interest, are necessary for the protection of investors, and unnecessarily or unfairly impede capital formation and economic growth. The proposals are likely to receive significant comments from private fund industry participants — both fund sponsors and fund investors — given the scope of the new requirements and new rules prohibiting longstanding practices that are the subject of negotiations between the advisers and investors as well as the potential unintended consequences of the proposals. Finally, we expect challenges to the proposed rule based on costs that the rules would impose on the industry, which the Commission estimates will exceed $3 billion, but have been challenged as significantly understated.
Despite the significant changes proposed, the public comment period for this proposal is only 30 days following publication in the Federal Register (which has not occurred as of the date of this alert) or April 11, 2022 (60 days after the rule was proposed), whichever is later. Once the comment period has closed, the Commission will review and consider those comments, and potentially repropose the new rules, before adopting final rules. Any rulemaking will take several months to complete, and the proposal includes a suggested one-year transition period for advisers to come into compliance with the rules, if and when adopted.
Prohibited Activities — Proposed Rule 211(h)(2)-1 (Prohibited Activities Rule)
The proposed rule would prohibit conduct by any private fund adviser — whether or not registered or required to be registered — that the Commission views as harmful to investors and as relating to sales and compensation practices and conflicts of interest. The Commission stated its view that “certain industry practices over the past decade… have persisted despite…enforcement actions and that disclosure alone will not adequately address.” The prohibited practices would be disallowed regardless of whether the activities had been described in the fund’s disclosure and governing documents. These prohibitions, if adopted, would fundamentally alter the historical approach to private fund structuring and economics and require significant changes to a range of negotiated arrangements among advisers, private funds, and their investors.
Under the proposed rule, the following practices would be prohibited for all private fund advisers.
|Proposed Rule 211(h)(2)-1 Prohibited Activities|
|Fees for Unperformed Services||Charging for monitoring, servicing, consulting, or other services the investment adviser does not, or does not reasonably expect to, provide to the portfolio investment (sometimes referred to as “accelerated payments”). The proposed rule would not prohibit an adviser from receiving payments in advance for services that it reasonably expects to provide in the future.|
|Certain Fees and Expenses||Charging fees or expenses associated with an examination or investigation of the adviser or its related persons by any governmental or regulatory authority as well as regulatory and compliance fees and expenses of the adviser or its related persons. Regulatory, compliance, and filing fees directly related to the activities of the private fund would still be permitted.|
|Reducing Adviser Clawbacks for Taxes
||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.|
|Limiting or Eliminating Liability for Adviser Misconduct
||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.|
|Certain Non-Pro Rata Fee and Expense Allocations||Charging or allocating fees and expenses related to a portfolio investment (or potential portfolio investment) on a non-pro rata basis when multiple private funds and other clients advised by the adviser or its related persons have invested (or propose to invest) in the same portfolio investment.|
|Borrowing||Borrowing or receiving a loan from a private fund client.|
Several of these proposed changes undermine primary differences between the funds subject to and those exempt from registration under the Investment Company Act. For example, “pro rata” allocation of fees and expenses among private funds is not defined and may not be fair and equitable for clients that have different tax or regulatory considerations. Additionally, restricting clawback provisions and enumerated fee and expense practices likely results in advisers’ being able to offer less flexibility to the types of large institutional private fund investors the Commission notes it is aiming to protect. These and numerous other considerations that arise from the proposed prohibitions will require exploration through the comment process.
Prohibited Preferential Treatment — Proposed Rule 211(h)(2)-3 (Preferential Treatment Rule)
The proposed rule would prohibit certain types of preferential treatment by any private fund adviser — whether registered or not — that the Commission has deemed to “have a material negative effect on other investors” which is a more rigorous standard than applies to an adviser with multiple separately managed accounts. For example, the proposed rule would prohibit private fund advisers from providing (i) preferential terms to certain investors regarding redemptions or information about portfolio holdings or exposures and (ii) any other preferential treatment to any investor in the private fund unless the adviser provides written disclosures to prospective and current investors in a private fund regarding all preferential treatment the adviser or its related persons are providing to other investors in the same fund. “Preferential” is not defined in the rule, and the Commission notes that whether any terms are “preferential” would depend on the facts and circumstances.
The proposed rule would prohibit without exception any right granted to an investor in the fund or a substantially similar pool of assets managed by the adviser or its related persons “to redeem its interest on terms that the adviser reasonably expects to have a material, negative effect on other investors” even if, for example, the investor could no longer legally hold the investment. Similarly, an adviser would be prohibited from providing information regarding the portfolio holdings or exposures of the private fund or of a substantially similar pool of assets to any investor if the adviser reasonably expects that providing the information would have a material, negative effect on other investors. The proposed rule appears to introduce a standard that would require advisers to conclude that there are no reasonably foreseeable material, negative effects on other investors. Moreover, a “substantially similar” pool may be difficult to identify and may be particularly difficult to manage when “related persons” are operationally independent.
Finally, without advance written disclosure to current and prospective investors, the proposed rule would also prohibit certain other preferential terms or the preferential sharing of other information. Advisers would be required to describe with specificity the preferential treatment and its relevance and provide disclosure to prospective investors prior to the investors making an investment. The adviser would need to distribute an annual notice to all current investors with the details of any preferential treatment provided to any investor since the last annual notice provided to investors.
Requirement to Deliver Quarterly Statements — Proposed Rule 211(h)(1)-2 (Quarterly Statement Rule)
The proposed rule would require a registered investment adviser to provide quarterly statements detailing fees, expenses, and performance to the investors in any private fund that it advises. Under the proposed rules, private fund advisers would be required to deliver to investors quarterly statements with required minimum disclosures. However, the Commission clarified that it is “not proposing to require private fund advisers to provide personalized account statements.”
The Commission requests comment on several different types of funds and funds for which compliance with the Quarterly Statement Rule appears to be particularly challenging. In its request for comment, the Commission does not appear to anticipate the challenges for many fund structures, including fund of funds, funds with pass-through expense structures, many types of private equity, real estate, real asset, venture capital, and other funds where reasonable and accurate valuations are not readily available on a quarterly basis to be reported within 45 days and where in some cases fees and expenses are not charged monthly or quarterly.
Fee and Expense Disclosures
Advisers to private funds would be required to prepare a “Fund Table” detailing adviser compensation with separate line items for each category of allocation or payment, fees, and expenses. The table would include fees and expenses paid by underlying portfolio investments to the adviser or its related persons and any offsets or rebates (as well as the amount of any offsets or rebates carried forward).
The proposed rule provides details concerning what is considered adequate disclosure at private-fund level and portfolio-investment level. Advisers would be required to “list each specific category of expense as a separate line item, rather than permit advisers to group expenses into broad categories.” Additional details to be included in the table would include any compensation paid to the adviser or an affiliate by a portfolio investment (both before and after any offsets, rebates, or waivers) along with the ownership percentage held by the fund of any portfolio investment that paid compensation to the adviser. Further, the proposed rule would require each quarterly statement to include disclosure regarding the manner in which expenses, payments, allocations, rebates, waivers, and offsets are calculated, including “cross references to the relevant section of the private fund’s organizational and offering documents that set forth the calculation methodology.” Requiring cross-references on these points could lead to a tangle of disclosures that could be less clearly understood than proper and adequate disclosure contained in the private fund’s organizational and offering documents, and both the disclosures and the line item expenses seem to require more than is required for a registered investment company.
In the context of the proposed Quarterly Statement Rule, the Commission again goes well beyond compliance issues, going so far as to suggest that the rule impose substantive limitations or caps on management fees or prohibit certain types of incentive fees, such as the “2 and 20 model,” that have been standard practices in the private fund industry for decades.
As proposed, the Quarterly Statement Rule would require private fund advisers to include standardized fund performance information in each quarterly statement provided to fund investors for each portfolio investment (defined as any entity in which the private fund has invested directly or indirectly).
The methodology for calculating performance would turn on whether the adviser to a private fund categorizes the fund as “liquid” or “illiquid” based on the definitions proposed in the Quarterly Statement Rule. As proposed, an illiquid fund would be defined as 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 to return 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. A liquid fund would be any private fund that is not an “illiquid fund,” which means that hybrid funds, evergreen funds, and other funds that are primarily illiquid, or pursue a strategy that is recognized as illiquid, will not satisfy all criteria and therefore be treated as “liquid” for these purposes.
For funds that qualify as “liquid” under the proposed rule, an adviser must show performance based on net total return on an annual basis since the fund’s inception, over prescribed time periods (one-, five-, and 10-calendar-year periods), and on a quarterly basis for the current year. Additionally, an adviser would be required to display the different categories of required performance information with equal prominence.
For illiquid funds, an adviser must show gross and net performance based on the internal rate of return (IRR) and a multiple of invested capital (MOIC) (computed without the impact of subscription facilities). The performance presentation for an illiquid fund would also need to present all contributions and distributions for the fund. The performance metrics for an illiquid fund would further need to be broken down and disclose the gross IRR and gross MOIC for each of the realized and unrealized portions of the illiquid fund’s portfolio.
The Commission notes that the Quarterly Statement Rule would not limit the presentation of other performance information for the private fund in the quarterly statement “as long as the quarterly statement presents the performance metrics prescribed by” the Quarterly Statement Rule. While acknowledging that some private funds will “not neatly fit into the liquid or illiquid designations,” the Commission has nonetheless proposed a framework that requires applying one designation or the other to each private fund and to provide the performance reporting required under that designation. All performance presentations would be required to include prominent disclosure of the criteria used and assumptions made in calculating the performance presented in the quarterly statement.
The quarterly statements would have to be prepared and distributed to fund investors within 45 days after each calendar quarter end and, for newly formed private funds, beginning after the fund’s second full calendar quarter of generating operating results.
Finally, an adviser would be required to consolidate reporting for substantially similar pools of assets to the extent doing so would provide more meaningful information to the private fund’s investors and would not be misleading. In the instance of a master-feeder fund structure, the adviser would be required “to provide feeder fund investors with a single quarterly statement covering the applicable feeder fund and the feeder fund’s proportionate interest in the master fund on a consolidated basis.”
Annual Financial Statement Audit Requirement — Proposed Rule 206(4)-10 (Audit Rule)
The proposed rule would also require registered investment advisers to cause each private fund they advise to undergo an annual financial statement audit. The Commission presents statistics on the overall trends of audits for private funds, noting that a substantial majority already undergo annual audits under Rule 206(4)-2 (the Advisers Act Custody Rule) that would satisfy this new requirement, but notes certain differences between the Custody Rule and proposed Audit Rule requirements. To comply with the requirements of the Audit Rule, the audit would need to meet the following requirements.
|Proposed Audit Rule 206(4)-10 Requirements|
|Requirements for Accountants||The accountant performing a private fund audit would be required to (1) meet the standards of independence and (2) be registered with, and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by the Public Company Accounting Oversight Board in accordance with its rules.|
|Auditing and Preparation Standards
||Audited financial statements would be required to be performed and prepared in accordance with generally accepted accounting principles (GAAP) or, if under non-U.S. law, a standard similar to GAAP.
|Prompt Distribution||Audited financial statements would be required to be distributed to current investors “promptly” after the completion of the audit; no prescribed deadline.|
The proposed rule would require advisers to have private funds audited annually and upon liquidation. For “prompt” distribution, the Commission considered requiring a fixed deadline similar to the 120/180-day reporting period under the Custody Rule but opted to provide advisers flexibility to meet the requirement and declined to set a specific fixed date (which, among other things, raises questions as to whether the new audit would require an earlier deadline than the existing rule). The rule is not clear whether it would apply to a fund of one when the audit is consolidated with the investor’s audit, or with respect to trading vehicles and special purpose vehicles that are consolidated in a fund audit, but does appear to provide flexibility for non-U.S. funds and advisers comparable to the flexibility under the Custody Rule. The proposed rule does not permit satisfaction of this requirement through a surprise annual examination for private fund advisers as is allowed under the current Custody Rule, which will eliminate surprise audits for private funds (which, notably, does not include funds that rely on exclusions other than Sections 3(c)(1) and (7)).
The proposed rule also would require private fund advisers to enter into a written agreement with the independent public accountant performing the audit to notify the Commission (i) promptly upon issuing an audit report to the private fund that contains a modified opinion and (ii) within four business days of resignation or dismissal from, or other termination of, the engagement or upon removing itself or being removed from consideration for being reappointed. The accountant making the notification would be required to provide its contact information and indicate its reason for sending the notification. These requirements are not covered in the existing audit exemption for pooled investment vehicles under the Custody Rule.
For advisers that do not control a private fund that they advise, the Commission would require that the adviser “take all reasonable steps” to cause its private fund client to undergo an audit that would satisfy the Proposed Audit Rule. The proposed rule does not define what would constitute “taking all reasonable steps” but indicates that efforts constituting all reasonable steps would depend on the facts and circumstances. The Commission asks whether the rule should apply to subadvisers.
Fairness Opinion Requirement for Adviser-Led Secondaries — Proposed Rule 211(h)(2)-2 (Adviser-Led Secondary Rule)
The proposed rule would require a registered adviser to a private fund to distribute to fund investors, prior to completing an adviser-led secondary transaction, (i) a fairness opinion from an independent opinion provider and (ii) a written summary of any material business relationships the adviser (or any of its related persons) has, or has had, within the past two years with the independent opinion provider. With the Adviser-Led Secondary Rule, the Commission identifies adviser-led secondary transactions as transactions that can provide liquidity for investors and secure additional time and capital to maximize the value of fund assets, however, according to the Commission, these transactions can also raise certain conflicts of interest. The Adviser-Led Secondary Rule intends to ensure that private fund investors are offered a fair price as a critical component of preventing the type of harm that might result from the adviser’s conflict of interest in leading the transaction.
The proposed rule defines an adviser-led secondary transaction as a transaction initiated by the adviser (or any of its related persons) that offers private fund 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).
Finally, the proposed rule would require the adviser to retain a copy of the fairness opinion and the material business relationship summary distributed to its fund investors, as well as a record of each addressee, the date(s) the opinion was sent, and delivery method.
The proposed definition of an adviser-led secondary transaction intends to capture a transaction initiated by the adviser (or any of its related persons) that offers private fund investors either (i) the choice to sell their interests or (ii) the choice to convert or exchange their interests for interests in another vehicle advised by the adviser (or any of its related persons) and not as currently proposed “… the choice to (i) … or (ii) ….” The proposed definition would include adviser-led secondary transactions (i) where a fund is selling one or more assets to another vehicle managed by the adviser (or its related persons), if investors have the option either to obtain liquidity or to roll all or a portion of their interests into the other vehicle, including single-assets, strip-sale, and full-fund restructuring transactions, or (ii) that may not involve a cross-sale between two vehicles managed by the same adviser, such as tender offers. However, whether the adviser or its related person initiates a secondary transaction requires a facts and circumstances analysis. Generally, a transaction would not be adviser-led if the adviser, at the unsolicited request of the investor, assists in the secondary sale of such investor’s fund interest.
The Commission requests comment with respect to whether certain adviser-led transactions should be exempt from the proposed rule, such as (i) transactions where the adviser conducts a competitive sale process for the assets being sold, which can provide an alternative way to validate pricing, (ii) transactions where the underlying assets being sold are predominantly publicly traded securities, or (iii) hedge fund restructurings where an adviser may be merging the portfolios of two different hedge funds and gives all affected investors the option to redeem or convert/exchange their interests into the new fund. Conversely, the Commission requests comment with respect to whether other transactions should require fairness opinions, such as bridge financings or syndications, where the selling fund transfers the investments within a short period at a price equal to cost plus interest to another affiliated fund.
The proposed rule defines an “independent opinion provider” as a provider that (i) provides fairness opinions in the ordinary course of its business and (ii) is not a related person of the adviser. The Adviser-Led Secondary Rule does not offer an exclusive list of material business relationships between an adviser (or any of its related persons) and an independent opinion provider that will need to be summarized and distributed to fund investors but provides that whether a business relationship would be material under the proposed rule would require a facts and circumstances analysis, and the Commission believes that audit, consulting, capital raising, investment banking, and other similar services would typically meet this standard.
Written Documentation of Compliance Program Annual Reviews — Amended Rule 206(4)-7
Finally, the Commission proposes to amend Rule 206(4)-7 (the Compliance Rule) under the Advisers Act, which currently requires all registered investment advisers to review annually the adequacy of the adviser’s policies and procedures. The Commission proposes to amend this rule to require all registered investment advisers — not just advisers to private funds — to document their annual review in writing.
The proposed amendment does not specify any reporting elements that must be included in the written documentation. Instead, in explaining the benefits of written reports, the Commission recites the requirements of Rule 38a-1 under the Investment Company Act, which requires, among other things, an annual compliance report to a registered fund’s board of directors, including (i) the operation of the compliance policies and procedures of the registered fund and each investment adviser of the registered fund; (ii) any material changes made to those policies and procedures since the date of the last report; (iii) any material changes to the policies and procedures recommended as a result of the annual review of its policies and procedures; and (iv) each material compliance matter that occurred since the date of the last report. The Commission acknowledges that it considered those requirements when considering the proposed changes to the Advisers Act Compliance Rule and the requirement to document in writing the annual review of an adviser’s compliance program.
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