The SEC adopted new rules and amendments designed to increase transparency and protect investors in private funds. The changes impacting advisers registered with the SEC under the Investment Advisers Act of 1940 were released August 23, 2023.
Private fund gross asset value has effectively doubled over the past seven years, from $10.3 trillion in the fourth quarter of 2015 to $20.5 trillion in the fourth quarter of 2022.
These private funds have become important to financial markets, increasing exposure for direct investors and indirect investors participating in pension plans, retirement plans, endowments, and foundations.
As a result, the SEC is tailoring their rules to address risk and harm to investors and restrict adviser activity contrary to the public interest and protection of investors.
Rule Changes
The new rules require private fund advisers registered with the SEC to:
- Provide investors with quarterly statements detailing information regarding private fund performance, fees, and expenses
- Obtain an annual audit for each private fund
- Obtain a fairness opinion or valuation opinion in connection with an adviser-led secondary transaction
The new rules require that all private fund advisers:
- Not engage in certain activities and practices that are contrary to the public interest and the protection of investors unless they provide certain disclosures to investors, and in some cases, receive investor consent
- Not provide certain types of preferential treatment that have a material negative effect on other investors and prohibit other types of preferential treatment unless disclosed to current and prospective investors
The effective date for the Private Fund Audit Rule and the Quarterly Statement Rule will be effective 18 months after the date of publication in the Federal Register.
The effective dates for the Adviser-Led Secondaries Rule, the Preferential Treatment Rule, and the Restricted Activities Rule will be:
- For advisers with $1.5 billion or more in private funds assets under management: 12 months after the date of publication in the Federal Register
- For advisers with less than $1.5 billion in private funds assets under management: 18 months after the date of publication in the Federal Register
The Compliance Rule will be effective 60 days after publication in the Federal Register.
Updated Requirements
The quarterly statement, audit, and adviser-led secondaries rules apply to all SEC-registered advisers. The restricted activities and preferential treatment rules apply to all advisers to private funds, regardless of whether they are registered with the SEC.
Registered Private Fund Advisers
Quarterly Statement Rule
Registered private fund advisers must distribute a quarterly statement to private fund investors. The statement must disclose fund-level information regarding performance, the cost of investing in the private fund, fees and expenses paid by the private fund, as well as certain compensation and other amounts paid to the adviser.
Private Fund Audit Rule
Registered private fund advisers must have the private funds they advise to undergo a financial statement audit that meets the requirements of the audit provision in the Investment Advisers Act Custody Rule 206(4)-2.
Under Rule 206(4)-2, an independent public accountant registered with the Public Company Accounting Oversight Board (PCAOB) must perform an annual audit of the financial statements of a pooled investment vehicle and deliver it to investors within 120 days of year-end or promptly upon liquidation.
Auditors are required to maintain SEC independence with the advisers and the advisers’ affiliates. As the financial statements are prepared in conformity with GAAP, assets and liabilities will be required to be recorded at fair value each reporting period.
These audits will provide an important check on the adviser’s valuation of private fund assets and protect private fund investors against the misappropriation of fund assets.
Adviser-Led Secondaries Rule
A registered private fund adviser must obtain a fairness opinion or a valuation opinion when offering existing fund investors the option between selling their interests in a private fund and converting or exchanging their interests in the private fund for interests in another vehicle advised by the adviser or any of its related persons.
Advisers also must prepare and distribute to the private fund’s investors a summary of any material business relationships the adviser has or had within the prior two years with the independent opinion provider. This requirement will be a check against an adviser’s conflicts of interest in structuring and leading such transactions.
Books and Records Rule Amendments
To facilitate the SEC’s ability to assess an adviser’s compliance with the rules, the reforms include amendments to the books and records rule under the Investment Advisers Act for registered private fund advisers.
All Private Fund Advisers
The reforms include new rules for private fund advisers.
Restricted Activities Rule
To address certain conflicts of interest that have the potential to lead to investor harm, the reforms include a new rule that restricts all private fund advisers from engaging in the following activities that are contrary to the public interest and the protection of investors.
Charging or allocating to the private fund fees or expenses associated with an investigation of the adviser without disclosure and consent from fund investors is prohibited. An adviser may not charge fees or expenses related to an investigation that results or has resulted in a court or governmental authority imposing a sanction for a violation of the Investment Advisers Act or its rules.
Also, they must not charge or allocate to the private fund regulatory, examination, or compliance fees or expenses of the adviser, unless such fees and expenses are disclosed to investors.
Reducing the amount of an adviser clawback by the amount of certain taxes, unless the adviser discloses the pre-tax and post-tax amount of the clawback to investors isn’t permitted.
They must not charge or allocate fees or expenses related to a portfolio investment on a nonpro rata basis, unless the allocation approach is fair and equitable and 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.
Borrowing or receiving an extension of credit from a private fund client without disclosure to, and consent from, fund investors isn’t permitted.
Preferential Treatment Rule
To address material negative effects of specific types of preferential treatment on other investors, the reforms prohibit all private fund advisers from providing preferential terms to investors regarding:
- Certain redemptions from the fund, 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
This rule also prohibits all private fund advisers from providing 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.
Legacy Status
The SEC is providing legacy status for the prohibitions aspect of the Preferential Treatment Rule and the aspects of the Restricted Activities Rule that require investor consent. The legacy status provisions apply to governing agreements that were entered into prior to the compliance date if the applicable rule would require the parties to amend the agreements.
All Registered Advisers
Compliance Rule Amendments
The reforms include amendments to the compliance rule under the act requiring all registered advisers, including those not advising private funds, to document in writing the required annual review of their compliance policies and procedures.
Written documentation of the annual review will help the SEC determine advisers’ compliance with the rules and identify potential compliance program weaknesses.
The Quarterly Statement Rule, Private Fund Audit Rule, Adviser-Led Secondaries Rule, Restricted Activities Rule, and Preferential Treatment Rule don’t apply to investment advisers with respect to securitized asset funds they advise.
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To learn more about the SEC private Fund Adviser Reform, contact your Moss Adams professional.
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