SEC Adopts Expansive (Albeit Slightly Softened) Private Funds Rules

Today, the SEC (U.S. Securities and Exchange Commission) has adopted the much anticipated so-called “Private Funds Rules” under the Investment Advisers Act of 1940 (the “Advisers Act”).¹   The Private Funds Rules will impact not just SEC-registered investment advisers but also exempt reporting advisers, state-registered investment advisers and other unregistered investment advisers. The Private Funds Rules represent a substantial expansion of the SEC’s regulation of private fund advisers that will likely have a significant impact on future SEC examination and enforcement activities. However, the SEC did soften the Private Funds Rules from the proposed version² in certain important ways, although certain of the prohibitions have been replaced with reporting and consent requirements that in certain circumstances may be onerous.

For all investment advisers to private funds, the Private Funds Rules include: (i) new restrictions on certain conflicted activities, including with respect to charging or allocating certain fees and expenses and on reducing the adviser’s clawback for certain taxes (but with certain exceptions where the activity meets disclosure requirements and, in certain circumstances, investor consent requirements), and (ii) new prohibitions on preferential treatment relating to redemptions and information (unless the preferential treatment is offered to all investors) and increased transparency on other types of preferential treatment.

For SEC-registered investment advisers to private funds, the Private Funds Rules also include (i) new quarterly statements to investors on performance, fees and expenses, and adviser and related person compensation, (ii) enhanced annual audit requirements, and (iii) new requirements relating to adviser-led secondary transactions (including a requirement to obtain a fairness opinion or valuation opinion).

In a departure from the proposed rules, the SEC has, among other changes, (i) dropped a prohibition on a liability standard above a negligence standard, (ii) provided exceptions from certain of the prohibited conflicted activities and preferential treatment with appropriate disclosure and, in certain circumstances, investor consent (which functionally convert most (but not all) of these prohibitions into disclosure requirements), and (iii) included a grandfathering provision that will cover agreements entered into prior to the Compliance Date (defined below) if an amendment to the agreement is required.

This slight softening from the proposed rules³ suggests that the SEC may also not seek to adopt the most aggressive versions of their other proposed rules, but that the adopted rules will likely still represent a material departure from existing practices.

The Private Funds Rules are set to go effective 60 days after publication in the Federal Register. With respect to the restricted activities, preferential treatment and adviser-led secondaries rules, there will be a staggered compliance period ending on (i) 18 months after the publication date (likely in summer of 2025) for investment advisers with less than $1.5 billion in in private fund assets and (ii) 12 months after the publication date (likely in early 2025) for investment advisers with $1.5 billion or more in private fund assets (the “Compliance Date”). With respect to the audit and quarterly statements rules, the Compliance Date will be 18 months for all private fund advisers.

We have briefly summarized the newly adopted rules below and will have additional detail forthcoming.

New Prohibitions and Requirements Applicable to All Private Fund Advisers (Including Registered Private Fund Advisers, Exempt Reporting Advisers And Other Unregistered Private Fund Advisers)

Restricted Conflicted Activities. All registered and unregistered private fund advisers would be prohibited from engaging in any of the following practices:

• Reducing the amount of an adviser clawback by actual, potential, or hypothetical taxes applicable to the adviser and its related persons, unless the adviser distributes a written notice that discloses the pre-tax and post-tax amount of the clawback to investors within 45 days after the end of the fiscal quarter in which the clawback occurs;
• Charging or allocating to the private fund
  • fees or expenses associated with an investigation of the adviser, unless there is disclosure to investors for such charge or allocation and written consent from at least a majority in interest of the investors for each specific instance (i.e., no prior blanket consent in the governing documents and no use of LP advisory committee for consent),
  • fees or expenses related to an investigation of the adviser that results or has resulted in a court or governmental authority imposing a sanction for a violation of the Advisers Act or the rules thereunder (with no exceptions),
  • regulatory, examination, or compliance fees or expenses of the adviser, unless the adviser distributes a written notice of any such fees and expenses (and the dollar amounts) to investors within 45 days after the end of the fiscal quarter in which the charge occurs, and
  • fees or expenses related to a portfolio investment on a non-pro rata basis, unless (i) the allocation approach is fair and equitable under the circumstances and (ii) the adviser distributes advance written notice of the non-pro rata charge and a description of how the allocation approach is fair and equitable under the circumstances; and
• Borrowing or receiving an extension of credit from a private fund client, unless the adviser (i) distributes to each investor a written description of the material terms of such borrowing or extension of credit and (ii) obtains written consent from at least a majority in interest of the private fund’s investors.

Functionally, with the limited exception of fees and expenses relating to sanctions for violation of the Advisers Act, this rule is more a set of disclosure requirements with respect to the conflicted activities rather than straight prohibitions. However, certain of the disclosure and consent requirements are onerous and may dissuade investment advisers from charging or allocating the restricted fees and expenses.

Preferential Treatment Restrictions. All registered and unregistered private fund advisers would be prohibited from providing preferential terms relating to (i) certain redemptions, unless the ability to redeem is required by applicable law or the adviser offers the preferential redemption rights to all other investors without qualification and (ii) certain preferential information about portfolio holdings or exposures, unless such preferential information is offered to all investors.

All registered and unregistered private fund advisers would also be prohibited from providing other preferential treatment to investors, unless certain terms are disclosed in advance of an investor’s investment in the private fund and all terms are disclosed after the investor’s investment.

Grandfathering. The Private Funds Rules would provide a grandfathering provision with respect to these restricted conflicted activities and the preferential treatment for agreements that were entered into prior to the compliance date, but only if the applicable rule would require the parties to amend the agreement. It would not cover the disclosure requirements of the preferential treatment rule or the prohibition on charging fees associated with a violation of the Advisers Act.

New Prohibitions and Requirements Applicable to Registered Private Fund Advisers

Quarterly Statements on Performance, Fees and Expenses. An SEC-registered private fund adviser would be required to distribute a quarterly statement to investors with:

• A detailed accounting of all fees and expenses paid during the reporting period;
• Information regarding compensation and other amounts paid by the private fund’s portfolio investments to the adviser or its related person; and
• Information regarding the private fund’s performance with different specific requirements for “liquid” funds and “illiquid funds.”

Annual Audit Requirement for Each Private Fund. An SEC-registered private fund adviser would be required to subject its private funds to undergo an audit that meets the requirements of the Custody Rule (Advisers Act Rule 206(4)-2). The SEC has separately proposed significant changes to the audit requirements under the Custody Rule in the new proposed Safeguarding Rule.⁴

Adviser-Led Secondary Transaction Requirements. An SEC-registered private fund adviser would be required to (i) obtain (and distribute to investors) a fairness opinion or valuation opinion in connection with an adviser-led secondary transaction from an independent opinion provider and (ii) prepare and distribute to investors a summary of any material business relationships between the adviser and any of its related persons with the independent opinion provider over the past two years.

Exception for Securitized Asset Funds. There would be an exception from the Private Funds Rules for investment advisers with respect to securitized asset funds they advise.

Other Amendments. The SEC is also proposing amendments to (i) the compliance rule (Advisers Act Rule 206(4)-7) applicable to SEC-registered investment advisers to require the annual review be documented in writing and (ii) the books and records rule (Advisers Act Rule 204-2) reflecting the requirement to retain records related to these new rules and amendments.

 

---

^[1] Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, SEC Release No. IA-6383 (Aug. 23, 2023).
^[2] Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, SEC Release No. IA-5955 (Feb. 9, 2022). For additional information on the original proposal, please see our Client Alert: Gregory Larkin, Brynn D. Peltz, Cynthia Wells, Daniel Ji, and Justin Kanter, “SEC Proposes Radical Changes to Private Fund Regulation” Goodwin, February 9, 2022 and Client Alert: Gregory Larkin and Brynn D. Peltz, “Private Funds Rules Set to Be Adopted—What to Watch For” Goodwin, August 16, 2023.
^[3] See, e.g., Client Alert: Gregory Larkin, Brynn D. Peltz, Cynthia Wells, Daniel Ji, and Justin Kanter, “SEC Proposes Radical Transformation of Custody Rule Into New Safeguarding Rule” Goodwin (Feb. 16, 2023).
^[4] See Client Alert: Gregory Larkin, Brynn D. Peltz, Cynthia Wells, Daniel Ji, and Justin Kanter, “SEC Proposes Radical Transformation of Custody Rule Into New Safeguarding Rule” Goodwin (Feb. 16, 2023).