The SEC’s New Private Funds Rules on Preferential Treatment: How Do They Compare With the AIFMD?

The US Securities and Exchange Commission (SEC) recently adopted new rules for private fund managers, which we covered in our alert SEC Adopts Expansive (Albeit Slightly Softened) Private Funds Rules.

The new rules include restrictions on preferential treatment of investors, which the EU Alternative Investment Fund Managers Directive (AIFMD) also addresses. Noting that there are various instances that could bring an EU AIFM within the scope of the new SEC rules, we examine how the new obligations under the SEC rules compare with those that AIFMs are subject to under EU member state laws (and UK law and regulation) implementing the AIFMD.

Some Context

Side letters and most-favored-nations (MFN) provisions allow fund houses to incentivise early, large, or strategic commitments, and give investors the ability to negotiate bespoke terms. Common side letter provisions include fee breaks, limited partner advisory committee (LPAC) seats, reporting requirements, ESG, tax or regulatory provisions, and excuse and transfer rights.

The MFN process typically involves the manager disclosing all side letter terms to investors after final close, following which each investor can take advantage of terms agreed with other investors — in many cases, based on having committed the same amount as, or more than, that investor (subject to some exceptions). Regulatory overlay is aimed at ensuring transparency and fairness.

When the SEC Rules Might Apply to an AIFM

Non-US advisers will typically be exempt from the new SEC private funds rules with respect to their non-US funds, including the restrictions on preferential treatment of investors (whether or not the non-US funds have US investors and/or make US investments). That said, there are various instances that could bring a non-US adviser within the new rules — for example, where a fund structure includes a Delaware feeder or parallel vehicle or has a US sub-adviser, where the non-US adviser is a “relying adviser” of an affiliated US adviser, or where a manager or adviser is a joint venture (JV) with a US adviser (unless there is sufficient independence between the JV manager/adviser and the US adviser).

These firms are therefore likely to be subject to both the AIFMD’s provisions on the fair treatment of investors and the SEC’s new private funds rules on preferential treatment. Whether or not a non-US adviser has to comply with respect to a particular fund, we expect that managers will still want to monitor the new SEC regulatory approach and consequent impact on investor expectations, disclosure and reporting practices, and market developments in general — and thus the shape of their policies and best practices.

Disclosures for Preferential Treatment in General

SEC New Rule

AIFMD Provision

All registered and unregistered private fund advisers (including exempt reporting advisers) are prohibited from providing preferential treatment to investors in the same private fund, unless:

Material economic terms provided to other investors are disclosed in advance of an investor’s investment in the private fund.
All terms that are provided are disclosed as soon as reasonably practicable following the fundraising period (for an illiquid fund) or after the investor’s investment (for a liquid fund).

An AIFM, for all AIFs it manages, must not allow any investor in an AIF to obtain preferential treatment, unless such preferential treatment is disclosed in the relevant AIF’s rules or instrument of incorporation.

Comment The SEC rule for prior disclosure to new investors has a materiality threshold and requires specificity on the material economic terms. This specificity would involve disclosure on the actual preferential fee rate given, for instance, but not the identity of the investor/investor group. Otherwise the SEC rule is similar to the AIFMD provision: bespoke economic terms given to investors can vary, based on commitment amount or otherwise, provided they are disclosed. Under the AIFMD, when an AIFM is prepared to grant an MFN provision, a reasonably detailed summary of the types of preferential treatment that may be afforded to investors — and the types of investors who may obtain such preferential treatment — is also required in the PPM and/or the LPA (or equivalent document). In addition, the AIFMD mandates precontractual investor disclosures for the AIFM to describe how it ensures a fair treatment of investors.

The second limb of the SEC rule mandates disclosure of all side letter terms to investors after the end of fundraising. In practice, this means providing copies of all side letters, on a redacted basis, or a summary of the preferential terms that have been provided — which is already a common approach for managers that are subject to the AIFMD.

Restrictions on Preferential Redemption and Information Rights

SEC New Rule

AIFMD Provision

In addition to the above, all registered and unregistered private fund advisers (including exempt reporting advisers) would be prohibited from providing preferential terms to investors in the same private fund or similar pool of assets that the adviser reasonably expects to have a material negative effect on other investors in the same fund or a similar pool of assets relating to:

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
Certain preferential information about portfolio holdings or exposures, unless such preferential information is offered to all investors

Any preferential treatment accorded by an AIFM to one or more investors shall not result in an overall material disadvantage to other investors. There is also an overriding obligation to treat investors fairly. The interaction of these two provisions means that an AIFM must treat investors fairly but need not treat them identically.

Comment The SEC rule is arguably more narrowly tailored and prescriptive than the AIFMD, in our view taking a more “rule” than “principles-based” approach to this piece of regulation. Permitted exceptions would be redemptions of government plan or ERISA investors due to legal requirements but not due to an investor’s own policy or stated preferences. The materiality test in both cases involves an analysis of facts and circumstances at the time the treatment is granted. However, particularly with respect to a preferential redemption right, the SEC staff are likely to take the position that the materiality threshold is low.

On its face, this leaves fund advisers subject to the SEC rule with less discretion than AIFMs as to preferential redemption or information rights in a side letter. Unless an exception applies, US advisers will have to offer the same redemption ability to all other existing (and future) investors without qualification (e.g., no commitment size — or other — requirement), including those in pooled funds such as feeder funds, parallel funds and alternative investment vehicles. In contrast, AIFMs will continue to be able to consider any overall material disadvantage to an investor of preferential redemption or information rights given to another investor type, provided it is disclosed (as set out above).

Annual Notice Requirement

SEC New Rule

AIFMD Provision

Advisers to provide annual updates to investors of specific details of all preferential treatment it has provided (although, as for the other disclosures set out above, specific investor type/group does not need to be provided). No update is needed where there have been no changes regarding preferential treatment (i.e., no new investors and no new terms provided) since the previous notice.

AIFMs to include details of preferential treatment as part of its annual reporting to regulators and to investors.

Comment

Both rules include retrospective investor reporting requirements; AIFMD includes explicit regulatory reporting on fair treatment too.

Practical Action Points

Managers/GPs subject to the new SEC rules will want to identify on a fund-by-fund basis any preferential redemption and information rights that would need to be offered to all investors in future fundraisings, along with any other material economic terms that would need to be disclosed to all investors before they subscribe. They will also want to review side letter disclosure practices to ensure that preferential terms are disclosed in time and that annual updates are provided for any additional rights granted. SEC grandfathering provisions may help, as preexisting funds whose governing documents were entered into before the compliance date and that under the new rule would require amendment (e.g. to be able to offer redemption rights to all investors where this was previously restricted in the fund documents) would be exempt from the restrictions on preferential treatment with respect to redemption and information rights. No such legacy status is being applied to the new disclosure and notice requirements detailed above. Therefore, commencing on the compliance date (likely to be in 2025), all private fund advisers subject to the new SEC rules will need to start making the required disclosures and notices of all preferential treatment with respect to all existing funds.

We continue to watch how market practice evolves in this area, including tracking the developments in the lawsuit filed by the Managed Funds Association and others on 1 September challenging the SEC’s power in this area. The suit states that the adoption of the new private funds rules exceeds the SEC’s statutory authority, fails to address the stated objectives, and will harm institutional investors and their beneficiaries.

To discuss how the SEC private funds rules may impact your fund structures and investments or any aspects of the SEC rules, please speak to your usual Goodwin contact or one of the co-authors of this briefing.