SEC adopts private fund rules – initial insights

The Securities and Exchange Commission (SEC) has adopted a series of new rules and rule amendments (the Final Rules)¹  that will significantly impact how private fund advisers operate their businesses and interact with investors. While the Final Rules likely will increase regulatory and compliance burdens and expenses for private fund advisers, they have been softened in certain respects relative to the SEC’s initial proposal.²

The Final Rules will become effective 60 days after publication in the Federal Register (the effective date), with staggered compliance dates as described in more detail below.

Key changes from the SEC’s initial proposal

• New rules will not apply to securitized asset funds. The five Final Rules applicable to private fund advisers will not apply to advisers with respect to the securitized asset funds they advise.³  Consistent with the corresponding definition in Form PF and Form ADV, a securitized asset fund is defined as a vehicle established for the purpose of issuing asset backed securities, such as collateralized loan obligations (CLOs).⁴


• Changes to prohibited activities. The renamed Restricted Activities Rule permits advisers to engage in certain activities so long as they provide appropriate disclosure and, in some cases, obtain investor consent. Specifically, the Final Rules did not include the proposed express prohibition on charging a portfolio investment fees for monitoring, servicing, consulting or any services that the investment adviser would not, or would not reasonably expect to, provide to such investment. The Reduction of Adviser Clawbacks Rule still permits adviser clawbacks net of actual, potential or hypothetical taxes, if appropriate disclosures are provided.


• Elimination of prohibition on seeking indemnification. In a departure from the proposal, the Final Rules will not prohibit an adviser from seeking reimbursement, indemnification or exculpation for simple negligence and breach of fiduciary duty.⁵


• Legacy status. The prohibitions provided in the Preferential Treatment Rule and aspects of the Restricted Activities Rule that require investor consent will not apply to existing funds and their governing agreements that were entered into prior to the Final Rules taking effect if compliance with such rules would require the parties to amend such agreements. Notably the SEC did not afford legacy status to the disclosure aspects of these rules (ie, advisers must disclose side letters that were entered into before the Compliance Date).


• Mandatory private fund audits. All required private fund audits must comply with the audit provisions under the Custody Rule,⁶  effectively eliminating the surprise examination option for private fund advisers.

Effective dates

Final rules	Effective dates
Amended Advisors Act Compliance Rule	60 days after publication in the Federal Register
Audit Rule and Quarterly Statement Rule	18 months after the effective date
Preferential Treatment Rule, Restricted Activities Rule and Adviser-Led Secondaries Rule:
Large private fund advisers ($1.5 billion or more in private fund assets under management)	12 months after the effective date
Smaller private fund advisers (less than $1.5 billion in private fund assets under management)	18 months after the effective date

 

Final rules applicable to all private fund advisers

The Preferential Treatment Rule and Restricted Activities Rule apply to all advisers to private funds, regardless of whether they are registered with the SEC or one or more states, including exempt reporting advisers.

Preferential Treatment Rule. The Rule generally prohibits private fund advisers from providing certain preferential terms, with respect to:

• Redemption rights if the adviser reasonably expects to have a material, negative effect on other investors, except in the following instances: (1) the adviser has offered the same redemption rights to all other existing investors in the same private fund or similar pool of assets and will continue to offer the same redemption ability to all future investors in the same private fund or any similar pool of assets or (2) the redemptions are required by law, rule, regulation, or order of certain government authorities.


• Information rights about portfolio holdings or exposures if the adviser reasonably expects that providing the information would have a material, negative effect on other investors, except in instances where the adviser offers such information to all other existing investors in the same private fund or similar pool of assets at the same time or substantially the same time.


• Any investor, unless the adviser provides (1) advance written notice prior to a prospective private fund investor’s investment in the private fund that describes specific information regarding any preferential treatment related to any material economic terms that the adviser or its related persons provide to other investors in the same private fund and (2) written notice to current investors in the private fund, at least annually, providing specific information regarding any preferential treatment provided by the adviser or its related persons to other investors in the same private fund. The timing of such notice to current fund investors depends on the type of fund. Closed-end funds⁷  must provide such disclosure as soon as reasonably practicable following the end of the private fund’s fundraising period, and open-end funds⁸  must do so as soon as reasonably practicable following the investor’s investment in the private fund.

Restricted Activities Rule. In a change from the proposal, the SEC staff modified the prohibited activities proposal to provide advisers with the ability to continue to engage in certain market practices, provided that investor disclosure is given and/or investor consent is obtained.

Permitted with written disclosure

• Reduction of adviser clawbacks. An adviser may reduce the amount of an adviser clawback by actual, potential, or hypothetical taxes if the adviser provides written notice to private fund investors (eg, on a registered advisers’ quarterly statement) that sets forth the aggregate dollar amounts of the adviser clawback before and after any reduction for actual, potential, or hypothetical taxes within 45 days after the end of the fiscal year in which the clawback occurs.


• Non-pro rata allocation of portfolio investment fees and expenses. An adviser may not charge or allocate fees or expenses related to a portfolio investment (or a 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 (1) the non-pro rata charge or allocation is fair and equitable and (2) the adviser provides each private fund investor with a written notice of the non-pro rata charge or allocation and a description of how it is fair and equitable under the circumstances.


• Regulatory and compliance fees. An adviser may charge a private fund regulatory or compliance fees, provided that written notice, including a detailed accounting, is distributed to investors describing the dollar amount of such fees and expenses within 45 days after the end of the fiscal quarter (eg, on a registered advisers’ quarterly statement) in which the charge occurs.

Permitted with written disclosure and consent

• Investigation fees or expenses. An adviser may charge a private fund any fees or expenses related to an investigation of the adviser or its related persons by any governmental or regulatory authority, provided the investigation does not result in sanctions for violations of the Advisers Act (as addressed in more detail below) and the adviser requests each investor to consent to such charge and obtains written consent from at least a majority in interest of the private fund’s investors that are not related persons of the adviser.


• Borrowing from private fund clients. An adviser may not engage in borrowings from a private fund client unless the adviser distributes a written notice and description of the material terms of the borrowing to the investors of the private fund, seeks their consent for the borrowing and obtains written consent from at least a majority in interest of the fund’s investors that are not related persons of the adviser.

Prohibited items

• Investigation fees or expenses related to violations of Advisers Act. An adviser is prohibited from charging investigation fees or expenses related to an investigation by any governmental or regulatory authority that results in a court or governmental authority imposing a sanction on the private fund adviser for violating the Advisers Act or its underlying rules.

Final rules applicable to SEC-registered private fund advisers

Quarterly Statement Rule. The Quarterly Statement Rule requires an adviser to deliver a standardized statement to private fund investors that generally includes (1) a table containing a detailed accounting of all fees, expenses, carried interest, and other performance-based compensation paid by the private fund during the reporting period (before and after the application of any offsets, rebates, or waivers), as well as disclosure regarding the calculation methodology for those amounts and cross references to the sections of the governing documents setting forth the methodology and (2) a table disclosing all compensation and other amounts paid by the private fund’s portfolio investments to the adviser or any of its related persons (before and after the application of any offsets, rebates or waivers).⁹

Closed-end funds will be required to provide the gross and net internal rate of return and gross and net multiple of invested capital from inception through the end of the current calendar quarter showing figures with and without impact of any fund-level credit facilities. Open-end funds will be required to provide annual net total returns since inception (or for each fiscal year over the 10 years prior to the quarterly statement, whichever is shorter), average annual net total returns over prescribed time periods, and quarterly net total returns for the current fiscal year.

Adviser-Led Secondaries Rule. In connection with any adviser-led private fund secondary transaction,¹⁰  an adviser must obtain a fairness opinion or a valuation opinion in connection with private fund secondary transactions led by the adviser. An adviser also will be required to prepare and distribute to the private fund’s investors a written summary of any material business relationships the adviser has, or has had within the prior two years, with the independent opinion provider.

Books and Records Rule amendments. Advisers must retain records related to the Final Rules, including, for each private fund client, documentation substantiating the adviser’s determination that a private fund client is a closed-end fund or open-end fund.

Private Fund Audit Rule. Advisers will be required to obtain and distribute an annual financial statement audit, meeting the requirements of the Custody Rule audit provision, for the private funds they advise, directly or indirectly.

Compliance Rule amendment applicable to all registered investment advisers

Compliance Rule amendments. Amendments to the Compliance Rule will require that all registered advisers, including those that do not advise private funds, document the required annual review of their compliance policies and procedures in writing.

What next?

Stay tuned for additional resources from the DLA Piper Investment Funds team as we continue to evaluate the extensive impact the Final Rules will have on private funds and their advisers. Please sign up here to receive our alerts and stay up to date with the DLA Piper Investment Funds team.

To find out more about the Final Rule and its implications for your business, please contact any of us:

Era Anagnosti
Meghan Carey
Jesse Criz
Nat Marrs
David Parrish

 

¹ See Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, Release No. IA-6368 (Aug. 23, 2023) (the Adopting Release) available at https://www.sec.gov/files/rules/final/2023/ia-6383.pdf.
² Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, SEC Release No. IA-5955 (February 9, 2023) available at https://www.sec.gov/files/rules/proposed/2022/ia-5955.pdf.
³ The Quarterly Statement Rule, Private Fund Audit Rule, Adviser-Led Secondaries Rule, Restricted Activities Rule, and Preferential Treatment Rule do not apply to investment advisers with respect to securitized asset funds they advise.
⁴ A “private fund” is defined as an issuer that would be an investment company but for the exclusions contained in Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940. Notably, this definition does not include some funds including real estate funds that rely on Section 3(c)(5)(C) or take the position that they do not invest in “securities,” and the Final Rules expressly exclude securitized asset funds. While not technically subject to all of the Final Rules, all investment advisers are subject to the federal antifraud provisions and should take note of how the SEC interprets such obligations throughout the Adopting Release.
⁵ While not included in the Final Rules, the SEC reiterated that an adviser’s fiduciary duty applies to its private fund clients and emphasized that the antifraud provisions continue to apply to the adviser’s dealings with client and fund investors. The SEC specifically noted that an adviser cannot waive compliance with its federal antifraud liability without breach of its fiduciary duty to the private fund or otherwise, such a wavier would be invalid under the Advisers Act.
⁶ Advisers Act Rule 206(4)-2.
⁷ Adopting Release at 649-650. The Adopting Release refers to a closed-end fund as an “illiquid fund” to mean 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.
⁸ Id. at 650. The Adopting Release refers to an open-end fund as a “liquid fund” and means any private fund that is not an illiquid fund.
⁹ The rule requires quarterly statements to be prepared and distributed to investors in private funds within 45 days after the first three fiscal quarter ends of each fiscal year and 90 days after the end of each fiscal year. Advisers to funds of funds must prepare and distribute quarterly statements within 75 days after the first three fiscal quarter ends of each year and 120 days after the fiscal year end.
¹⁰ An “adviser-led secondary” means a transaction initiated by an adviser or its related persons that offers private fund investors the option between selling all or a portion of their interests in the private fund and converting or exchanging them for new interests in another vehicle advised by the adviser or any of its related persons.