The Final Private Fund Rules: The SEC’s “Transparent” Effort to Rebalance the Adviser-Investor Relationship

On August 23, 2023, the Securities and Exchange Commission (the SEC) adopted, by a 3-2 vote, a package of far-reaching new rules (the Private Fund Rules) [1] under the Investment Advisers Act of 1940, as amended (the Advisers Act).  These rules will be applicable to most investment advisers to private funds [2], including investment advisers that are registered or are required to register with the SEC under the Advisers Act (RIAs), as well as exempt reporting advisers (ERAs) and other advisers not required to register with the SEC, with all rules applying to RIAs and only certain of the rules (identified below) applying to ERAs and other unregistered advisers. [3] As adopted, the final Private Fund Rules are very similar to the rules originally proposed by the SEC in February of 2022 although they do contain some important — and, from the perspective of private fund advisers, beneficial — changes from what was originally proposed. 

Thematically, the Private Fund Rules are premised on the SEC’s belief that enhanced disclosure and transparency of information by private fund advisers to their investors will address what the SEC perceives as a primary weakness in private fund industry practices, namely conflicts of interest between advisers and their investors. However, while greater transparency may seem like an indisputable virtue, the volume and detail of information required by the new rules come with costs: the cost to advisers of complying with the new rules regime, including the costs associated with producing the many items of information and disclosure required under new rules, with some of these costs likely to be passed on to investors as fund expenses and the balance to be borne by advisers (and with larger AUM advisers generally able to absorb such increased costs more easily than smaller AUM advisers); the likely increased costs that advisers will incur in preparing for and going through future SEC exams in which the SEC exam staff will have the opportunity to review, and possibly find deficiencies with, an adviser’s compliance with the new rules and the quality and completeness of information that advisers will be required to provide; and the cost to investors of having to sift through the increased information they will be receiving as a result of the new rules. These costs cannot be understated, particularly when taken together with the compliance costs associated with other new SEC rules such as the new Marketing Rule and the recent changes to Form PF reporting. It may be that the primary beneficiaries of the Private Fund Rules will be the professionals and service providers — lawyers, accountants, compliance consultants, fund administrators, LP advisors/gatekeepers and valuation firms — to whom advisers and investors inevitably will have to turn to assist them in navigating the information superhighway that the SEC has built for the private funds industry.

Rules Applicable to RIAs Only

• Quarterly Statement Rule (Rule 211(h)(1)-2). Advisers will be required to provide investors with quarterly reporting (within 45 days of the end of the first three fiscal quarters and within 90 days after year-end, or 75 days and 120 days, respectively, for fund of fund advisers) that includes detailed information regarding (i) fees and expenses paid or incurred by the fund, (ii) compensation paid or allocated to the adviser or its related persons [4] by the fund or the fund’s portfolio investments, (iii) offsets or rebates carried forward to future reporting periods and (iv) fund-level performance information (including, among other things, disclosure of the fund’s gross and net internal rate of return (IRR) and multiple of invested capital (MOIC) since inception, with prescribed methods from calculating net and gross IRR and MOIC).  Fund performance reporting will differ depending on whether a fund is a “liquid” or “illiquid” fund [5]; for illiquid funds, fund performance must be presented both with and without the impact of fund-level subscription facilities.  Expense reporting will be required to be shown based on each category of expense charged or incurred (e.g., organizational, accounting, legal, administrative, audit, tax, due diligence, and travel expenses); as set forth in the adopting release, advisers will not be permitted to exclude de minimis expenses, group small expense items under broad categories, or label expenses as “miscellaneous”.  The quarterly statement is required to include prominent disclosure regarding the manner in which all expenses, payments, allocations, rebates, waivers, and offsets are calculated and must include cross-references to the applicable sections of the fund’s organizational documents. 
  
  [Compliance date:  18 months after the date of publication of the Private Fund Rules in the Federal Register]
  
  
• Private Fund Audit Rule (Rule 206(4)-10).  Advisers will be required to cause each private fund they advise to undergo an annual financial statement audit.  In an important change from the originally proposed rules, the final rules provide that an audit that complies with the current Custody Rule will satisfy this audit requirement.
  
  [Compliance date: 18 months after the date of publication of the Private Fund Rules in the Federal Register] 

• Adviser-Led Secondary Rule (Rule 211(h)(2)-2).  In connection with any adviser-led secondary transaction [6], advisers will be required to provide fund investors (prior to the date by which investors are required to make elections in connection with such secondary transaction) with either a fairness opinion or a valuation opinion from an independent opinion provider [7]; the inclusion of a “valuation opinion” option is a change from the originally proposed rules (this option was added based on commenter feedback that a valuation opinion might be a less cumbersome and costly option than obtaining a fairness opinion). Opinions must be accompanied by a written summary of certain business relationships between the opinion provider, on the one hand, and the adviser and its related persons, on the other, within the two-year period prior to the date the opinion is issued. Importantly, as provided in the adopting release, tender offers for LP interests generally will not be covered by the final rule; the SEC also confirmed that rebalancing transactions between a fund and a parallel fund during the marketing period of a fund and “season and sell” transactions are also outside the scope of this rule.
  
  [Compliance date: 18 months after the date of publication of the Private Fund Rules in the Federal Register for advisers with less than $1.5 billion in private fund assets under management (smaller private fund advisers) and 12 months after such date for advisers with $1.5 billion or more in private fund assets under management (larger private fund advisers)]  

Rules Applicable to RIAs, ERAs and Other Unregistered Advisers

• Restricted Activities Rule (Rule 211(h)(2)-1). The originally proposed rules set forth seven categories of “prohibited activities” in which advisers were not permitted to engage.  Two of these categories (discussed below) were eliminated altogether from the final rules and the remaining five (now referred to as “restricted activities”) are generally permitted under the final rules with disclosure and, in certain cases, investor consent.
  
  
  •  The two “prohibited activities” that were included in the originally proposed rules which have been eliminated from the final rules were  the prohibitions on an adviser (i) seeking reimbursement, indemnification, or limitation of its liability by a private fund or its investors for a breach of fiduciary duty, willful malfeasance, bad faith, negligence, or recklessness in providing services to the private fund (the limitation of liability prohibition), and (ii) charging a portfolio investment for monitoring, servicing, consulting or other fees in respect of any services that the adviser does not, or does not reasonably expect to, provide to the portfolio investment (the accelerated monitoring fee prohibition).  The limitation of liability prohibition included in the originally proposed rules was especially controversial among investment advisers as it would have fundamentally changed the allocation of risk in connection with private fund investment activities and likely would have exposed advisers to increased litigation risk.  Therefore, the exclusion of this prohibition from the final rules is a clear victory for private fund advisers. It is not clear whether the same can be said about the absence of the accelerated monitoring fee prohibition from the final rules because a member of the SEC staff stated at the August 23^rd public meeting on the final rules that the inclusion of this prohibition was unnecessary because charging these fees was already prohibited under existing SEC guidance.
    
    
  • The five categories of restricted activities covered by the final rules include:
    
    LP Notice Required for Reductions in Adviser Clawbacks for Taxes.  An adviser may not reduce the amount of their clawback obligations to private fund investors by the amount of certain taxes applicable to the adviser, its related persons, or their respective owners or interest holders unless the advisor discloses the pre-tax and post-tax amount of the clawback to investors within 45 days after the quarter end in which the clawback occurs (e.g., if a clawback obligation is triggered upon liquidation of a fund, within 45 days after the quarter end in which such date of liquidation occurs).
    
    LP Notice Required for Charging Regulatory, Examination or Compliance Costs.  An adviser may not charge a private fund for any regulatory, examination or compliance fees of the adviser or its related persons unless such amounts are disclosed to fund investors within 45 days after the quarter end in which such charge occurs.
    
    LP Notice, Plus a Determination of Fair and Equitable Treatment, Required for Non-Pro Rata Allocation of Fees and Expenses Among Commonly Managed Funds.  An adviser may not charge or allocate fees 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 unless (i) the allocation approach is fair and reasonable, and (ii) the adviser distributes advance written notice to fund investors of the non-pro-rata charge or allocation that includes a description of how the allocation approach taken is fair and equitable under the circumstances.
    
    LP Consent Required for Charging Investigation Expenses Where No Sanctions Are Involved; Prohibition on Charging Expenses Associated with Investigations Resulting in Sanctions.  An adviser may not charge a private fund for fees or expenses associated with an examination or investigation of the adviser or its related persons by any governmental or regulatory authority unless the adviser obtains the consent of a majority of the fund’s investors (excluding related persons of the adviser) to such charge and so long as such investigation does not result in a court or governmental authority imposing a sanction for a violation of the Advisers Act or the rules promulgated thereunder.  There is an absolute prohibition on charging such examination and investigation fees or expenses if an investigation results in any such sanction (and any fees or expenses charged to a fund prior to the imposition of a sanction would have to be returned to fund investors following the imposition of the sanction).
    
    LP Disclosure and Consent Required for Borrowings from Private Fund Clients.  An adviser may not borrow money, securities, or other private fund assets, or receive a loan or an extension of credit from a private fund client unless the adviser has disclosed to fund investors the material terms of such borrowing or other extension of credit and has obtained the consent of a majority of the fund’s investors (excluding related persons of the adviser)
    
    [Compliance date for the Restricted Activities Rule:  18 months after the date of publication of the Private Fund Rules in the Federal Register for smaller private fund advisers and 12 months after such date for larger private fund advisers]

• Preferential Treatment Rule (Rule 211(h)(2)-3)
  
  
  • The Private Fund Rules prohibit three categories of preferential treatment:
    
    Preferential Redemption Rights.  Advisers are prohibited from granting an investor in a private fund or in a similar pool of assets the ability to redeem its interest on terms that the adviser reasonably expects to have a material, negative effect on other investors in that private fund or in a similar pool of assets [8], other than (i) where the adviser has offered the same redemption rights to all existing investors and will continue to offer the same redemption rights to all future investors in the private fund or similar pool of assets or (ii) redemptions required by applicable law, rule or regulation, or order of certain governmental authorities (e.g., redemptions of ERISA investors pursuant to ERISA requirements or redemptions of governmental plan investors required as a result of violations by the adviser or its related persons of state pay-to-play laws).  Importantly, redemptions pursuant to an investor’s internal written policy are not a permitted exception to this rule.
    
    Preferential Transparency of Portfolio Information. Advisers are prohibited from providing information to an investor regarding portfolio holdings or exposures of a private fund or of a similar pool of assets if the adviser reasonably expects that providing such information would have a material, negative effect on other investors in that private fund or in a similar pool of assets unless such information is offered to all investors.
    
    Other Preferential Treatment.  Advisers are prohibited from providing any other preferential treatment to any investor in a private fund (e.g., rights typically offered to investors pursuant to side letters in addition to the preferential rights described above) unless (i) in the case of preferential material economic terms (including, but not limited to, terms relating to the cost of investing, liquidity rights, fee breaks and co-investment rights) offered to one investor, such terms are disclosed to other investors prior to their investment in the fund (by contrast, the originally proposed rules required advance, pre-commitment disclosure of all terms offered to other investors, not just material economic terms) and (ii) in the case of all other terms, such terms are disclosed to all investors in the fund as soon as reasonably practicable following the end of the fund’s fundraising period (or, in the case of a liquid fund, as soon as practicable following an investor’s investment in the fund), with annual updates thereafter to the extent additional preferential rights have been granted since the last notice.  Advisers may comply with the disclosure requirements set forth above by providing copies of side letters (with identifying information regarding other investors redacted) or a written summary of the preferential terms provided to other investors.
    
    [Compliance date for the Preferential Treatment Rule:  18 months after the date of publication of the Private Fund Rules in the Federal Register for advisers with smaller private fund advisers and 12 months after such date for larger private fund advisers] 

Legacy Status for Existing Funds

The Private Fund Rules provide certain funds with “legacy status” such that the Adviser would not be required to comply with certain portions of the Private Fund Rules with respect to those funds.  The portions of the new rules to which legacy status apply are (i) the prohibitions aspect of the Preferential Treatment rule (i.e., the prohibitions on providing certain preferential redemption rights and information about portfolio holdings) and (ii) the portions of the Restricted Activities Rule that require investor consent (i.e., for adviser borrowings from a private fund and for charging certain investigation fees and expenses to a private fund).  Legacy status does not apply to the Quarterly Statement Rule, the Private Fund Audit Rule, the Adviser-Led Secondaries Rule, or the disclosure portions of the Preferential Treatment Rule. [9] The legacy status provisions relate to a fund organizational agreement entered into prior to the applicable compliance date if the adviser would be required to amend such agreement as a result of the new rules, provided that the fund has commenced operations as of the compliance date.

Amendment to the Compliance Rule

Next Steps for Advisers

Although there may be legal challenges to Private Fund Rules, including on the basis that the SEC has exceeded its statutory authority in adopting the new rules in certain instances, it is unclear whether such challenges will be pursued (particularly since a few of the more onerous provisions of the originally proposed rules have been softened under the final rules or, in the case of the limitation on liability prohibition, eliminated altogether) and, if pursued, whether such challenges would be successful.  As such, advisers should plan ahead with the view that the Private Fund Rules will become a reality by sometime late next year or the first half of 2025 (depending on the rule in question and, in certain cases, whether an adviser is a smaller or larger private fund adviser) or, in the case of the amendments to the compliance rule, even earlier (as early as the end of this year).

In light of the adoption of the final Private Fund Rules, advisers should consider taking the following steps:

• For RIAs, an evaluation of their current reporting systems and protocols to determine the gap between what is currently provided to investors on a quarterly basis as compared to the information that will be required to delivered to investors under the Quarterly Statement Rule.
  
  
• For all advisers, a determination whether current internal and external resources are sufficient to meet the increased reporting and other compliance requirements of the Private Fund Rules or whether additional resources will be needed.
  
  
• For all advisers, a review of side letter disclosure practices of existing funds to determine whether they satisfy the disclosure requirements of the Preferential Treatment Rule (i.e., disclosure of preferential terms to all investors following the close of the fundraising period and annual updates thereafter for additional preferential rights granted).
  
  
• For all advisers, an examination of whether any existing fund side letters contain “material economic terms” such that, if those terms were offered to the same or another investor as part of a future fundraising by the adviser after the applicable compliance date, the adviser would be required to provide pre-commitment disclosure to other investors participating in such future fundraising.
  
  
• For RIAs, an examination of how best to harmonize fund performance reporting across the requirements of the Marketing Rule and Quarterly Statement Rule.
  
  
• For all advisers, a review of current and historic fund expense reimbursements with a view to developing discrete categories for quarterly expense reporting required under the Quarterly Statement Rule; in this regard, most fund LPAs have detailed descriptions of reimbursable fund expenses which should be examined in arriving at appropriate expense categories.
  
  
• For ERAs which rely on the venture capital exemption from registration under the Advisers Act (and which wish to maintain their exempt status), they should be especially vigilant in ensuring they continue to satisfy the requirements of this exemption given the increased burdens under the new rules (in particular, the Quarterly Statement Rule) that come with being a RIA (or an Adviser that is not a RIA but is required to register); in addition, since certain of the new rules (the Restricted Activities Rule and the Preferential Treatment Rule) apply to both RIAs and ERAs, VC-exempt ERAs should anticipate that the SEC may be more inclined to examine ERAs than it has in the past (it seems unlikely that the SEC would have provided that certain of the new rules apply to ERAs only to give them a pass when it comes to periodic examinations).

[1] The link to adopting release is attached https://www.sec.gov/files/rules/final/2023/ia-6383.pdf.

[2] Private funds are defined as funds that would be investment companies but for the exclusions set forth in Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940, as amended. In a change from the originally proposed rules, the final Private Fund Rules do not apply to securitized asset funds.

[3] The adopting release for the Private Fund Rules provides that, consistent with the SEC’s historical position that the substantive provisions of the Advisers Act do not apply to the non-U.S. private fund clients of offshore advisers, the final rules do not apply to offshore funds advised by offshore advisers (regardless of whether the funds have U.S. investors).

[4] “Related persons” include (i) all officers, partners, or directors (or any person performing similar functions) of the adviser, (ii) all persons directly or indirectly controlled by the adviser, (iii) all current employees (other than employees performing only clerical, administrative, support or similar functions), and (iv) any person under common control with the adviser. Some commenters to the originally proposed rules supported broadening the definition to include operational partners, senior advisors, or similar consultants, which the SEC declined to do, adopting a definition of “related persons” consistent with the definitions used in Form ADV and Form PF.

[5] An “illiquid fund” is a private fund that (i) is not required to redeem interests upon an investor’s request and (ii) has limited opportunities, if any, for investors to withdraw before termination of the fund. Most private equity and venture capital funds would be treated as illiquid funds.  A “liquid fund” is any private fund that is not an illiquid fund.

[6] An “adviser-led secondary transaction” is any transaction initiated by the adviser or any of its related persons that offers private fund investors the choice between (i) selling all or a portion of their interests in a private fund and (ii) converting or exchanging all or a portion of their interests in a private fund for interests in another vehicle advised by the adviser or any its related persons.

[7] An “independent opinion provider” is a person that provides fairness opinions in the ordinary course of its business and is not a related person of the adviser.

[8] “Similar pool of assets” refers to a pooled investment vehicle (other than a registered investment company or an entity that elects to be treated like a registered investment company, or a securitized asset fund) with substantially similar investment policies, objectives, or strategies to those of the private fund managed by the investment adviser or its related persons.

[9] An example of where legacy status would not apply is an adviser that previously disclosed preferential side letter provisions only to certain investors (e.g., those investors with “most favored nation” rights as part of their side letters requiring such disclosure) rather than all fund investors.  In this example, the adviser would have to disclose the side letter index to all fund investors even if the fund’s fundraising period closed many years in the past.