On August 23, 2023, the SEC adopted a new set of rules and rule amendments (the “New Rules”)1 under the Investment Advisers Act of 1940 (the “Advisers Act”) that arguably represent the most significant changes to the regulation of private funds2 and their advisers since the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Although the New Rules have been scaled back from the originally proposed version,3 the New Rules represent a substantial expansion in the scope of disclosure, reporting and other compliance requirements imposed on SEC-registered investment advisers, and in some cases, exempt report advisers, state-registered investment advisers and other unregistered investment advisers. The authorizing release detailing the New Rules spans over 600 pages, but the below provides a high-level summary of the New Rules and the significant disclosure, reporting and other compliance requirements thereunder.
Below is a summary of the New Rules that apply to all private fund advisers (regardless of registration status):
- Restrictions on Preferential Treatment:
- This rule prohibits all private fund advisers from offering preferential terms to certain investors regarding certain redemptions from the private fund or providing certain information about portfolio holdings or exposures, if the adviser reasonably expects such terms or providing such information, as applicable, will have a material, negative effect on the other investors in that private fund or a similar pool of assets, subject to limited exceptions. This portion of the rule has legacy status (i.e., grandfathers existing private funds), meaning that for this portion, parties do not need to amend governing agreements to comply so long as the governing documents were entered into prior to the compliance date of the rule, and so long as the private fund commenced operations as of the compliance date.
- This rule also prohibits all private fund advisers from providing any other preferential treatment to any investor in the private fund unless such adviser provides the required written disclosures. These disclosures must be provided in advance to prospective investors for any preferential material economic terms, and for all other preferential treatment (and on an annual basis thereafter for new preferential treatment) beginning (i) as soon as reasonably practicable following the end of the private fund’s fundraising period for an illiquid fund and (ii) as soon as reasonably practicable following the investor’s investment in the private fund for liquid funds.
- Restricted Activities:
- This rule prohibits all private fund advisers from directly or indirectly engaging in certain sales practices, conflict of interest, and compensation schemes, unless they provide written disclosure to investors and, in some cases, obtain the requisite investor consent regarding such activities. Portions of this rule are grandfathered similar to portions of the restrictions on preferential treatment rule described above.
- The above-referenced restricted activities are: (i) charging or allocating to a private fund expenses associated with an investigation of the private fund adviser or its related persons by regulatory authorities; (ii) charging or allocating to a private fund any regulatory, compliance, or examination expenses of such private fund adviser or its related persons by regulatory authorities; (iii) charging or allocating fees or expenses related to a portfolio investment that is invested (or proposed to be invested) in by multiple private fund adviser clients on a non-pro rata basis, unless it is fair and equitable under the circumstances; (iv) reducing the amount of an adviser’s or a related person’s clawback by actual, potential or hypothetical taxes; and (v) borrowing money, securities, or other private fund assets or receiving a loan or extension of credit from a private fund client.
Below is a summary of the New Rules that apply only to SEC-registered investment advisers for private funds:
- Quarterly Statement Requirements:
- This rule requires SEC-registered investment advisers to distribute to investors of a private fund, quarterly financial statements within 45 days (75 days for fund-of-funds) after the end of each of the first three fiscal quarters and within 90 days (120 days for fund-of-funds) after the end of the last fiscal quarter, which statements include significant standardized disclosure requirements relating to the private fund’s (and in some cases, its portfolio investments’) performance, fees and expenses.
- Annual Audit Requirements:
- This rule requires SEC-registered investment advisers to cause each private fund they advise to undergo a financial statement audit at least annually in accordance with the audit provision (and related requirements for delivery of audited financial statements) under the Custody Rule (Rule 206(4)-2), from a private fund’s inception through and including upon liquidation. However, unlike the Custody Rule, an SEC-registered investment adviser cannot opt out of delivering annual audited financials and instead be subject to a surprise examination.
- Adviser-Led Secondary Requirements:
- This rule prohibits SEC-registered investment advisers from completing an adviser-led secondary transaction with respect to any private fund, unless prior to the closing of the transaction, it obtains and distributes to the investors: (i) a fairness opinion or a valuation opinion from an independent opinion provider and (ii) a summary of any material business relationships that such adviser or its related person has, or has had, with the independent opinion provider over the past two years.
- Under this rule, an adviser-led secondary transaction means any transaction initiated by the SEC-registered investment 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 the private fund; and (ii) 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.
- Rule Amendments:
- The SEC amended Rule 204-2 under the Advisers Act (the “Recordkeeping Rule”) to require SEC-registered investment advisers to maintain certain books and records relating to the New Rules.
- The SEC also amended Rule 206(4)-7 (the “Compliance Rule”) to require all SEC-registered investment advisers (including those that do not manage private funds) to document their annual review of their compliance policies and procedures in writing.
The New Rules will be effective 60 days after publication in the Federal Register (the “Effective Date”) and the amended Compliance Rule will also have the same compliance date. The compliance date for the New Rules relating to the Quarterly Statement Requirements and Annual Audit Requirements will be 18 months after the Effective Date, while the compliance date for the New Rules relating to the Restrictions on Preferential Treatment, Restricted Activities and Adviser-Led Secondary Requirements will be effective 12 months after the Effective Date for large private fund advisers (i.e., AUM of $1.5B+) and 18 months after the Effective Date for small private fund advisers (i.e., AUM of less than $1.5B).
Should you have any questions regarding these New Rules, please do not hesitate to contact, co-authors Keith Kaplan and Nicole Haiem, or any other member of the Fund Formation Practice Group at Klehr Harrison.
2 Section 202(a)(29) of the Advisers Act defines a “private fund” as an issuer that would be registered under the Investment Company Act of 1940 but for its reliance on 3(c)(1) or 3(c)(7). In respect of the New Rules, this definition does not include any securitized asset funds, separate accounts or 3(c)(5) funds.