On August 23, the United States Securities and Exchange Commission (the “SEC” or “Commission”) adopted rules and rule amendments (the “PFA Rules”) under the Investment Advisers Act of 1940 (the “Advisers Act”) that impose new requirements and obligations on investment advisers to private funds. In our prior blog post on the PFA Rules, we briefly summarized the SEC’s additions to the regulatory landscape for private funds. This blog will focus on one aspect of the PFA Rules – how registered investment advisers must report on fees, expenses and performance on a regular basis to their investors.

According to the Commission’s adopting release announcing the PFA Rules, a central focus for the SEC was enacting requirements in the private funds markets that will give investors access to simple, clear and consistently formatted disclosures regarding the most important and fundamental terms of their relationships with private fund advisers – particularly as they relate to fees and expenses. Transparency around the fees and expenses charged by private funds has consistently remained among the top of the list of issues that both investors and managers are most concerned with in the fundraising process. With the enactment of the new rule focused on uniform quarterly reporting, the Commission now seeks to standardize the frequency, substance and formatting of such disclosures across the industry.

Under new Rule 211(h)(1)-2 under the Advisers Act (the “Quarterly Statement Rule”), private fund advisers that are registered (or that are required to be registered) with the SEC must prepare and distribute a quarterly statement to each investor in any private fund it advises that has at least two full fiscal quarters of operating results, in accordance with the following principles:

• Timing. The reports must be delivered within 45 days after the end of each of the first three fiscal quarters of each fiscal year of each private fund and 90 days after the end of each fiscal year of each private fund. For fund of funds structures, the reporting periods are extended to 75 days after the end of the first three fiscal quarters and 120 days after the end of the fiscal year.
• Methodology Disclosure. The statements for each quarter are required to have certain standardized disclosures related to performance, fees and expenses, and they must include “prominent disclosure” of the methods used to calculate all expenses, payments, allocations, rebates, waivers and offsets, and include cross references to the sections of the private fund’s organizational and offering documents that set forth the applicable calculation methodology.
• Format and Content. Quarterly statements must use clear, concise, plain English and be presented in a manner that facilitates an investor’s ability to easily compare fees, expenses and performance over each quarterly period.

The Commission also prescribed the formatting and baseline content of the quarterly reports. Specifically, registered investment advisers to private funds will now be required to prepare and deliver quarterly reports that include the following three standardized tables, in addition to any other information the advisers elects to provide:

• Table Disclosing Fund-Level Information. The following fund-level information must be presented in the statement both with and without the application of any offsets, rebates, or waivers:
  • All compensation, fees, and other amounts allocated or paid to the adviser or any of its related persons by the private fund during the reporting period. The table must separate line items for each category of allocation or payment reflecting the total dollar amounts for common outflows including management fees, advisory fees, and any performance-based compensation such as carried interest or incentive allocations.
  • A detailed reporting of all fees and expenses allocated to or paid by the private fund during the reporting period (without duplicating any of the above amounts paid to the adviser or its related person), with separate line items for each category of fee or expense reflecting the total dollar amount; and
  • The amount of any offsets or rebates (such as management fee offsets or similar arrangements) that are carried forward during the reporting period to later periods to reduce future payments or allocations to the private fund adviser or its related persons.
• Table Disclosing Portfolio Investments Generating Special Fees. This table discloses, for each portfolio investment that allocated or paid “investment compensation” to the adviser or any of its related persons (often referred to as “special fees” within the industry) during the reporting period, with separate line items for each category of allocation or payment, presented both before and after the application of any offsets, rebates or waivers.
• Table Reporting Fund Performance. The disclosures in the performance-related table depend on what kind of private fund is issuing the quarterly statement. The PFA Rules classify private funds into “liquid funds” and “illiquid funds”.
  • “Illiquid funds” are those that are not required to redeem interests upon an investor’s request and that have limited opportunities, if any, for investors to withdraw before the end of the fund’s term. Generally, private equity funds, venture capital funds, real estate funds, credit funds and similar investment vehicles fall under the category of “illiquid funds”. Advisers to these funds are required to include in the table of fund performance (A) gross IRR and gross MOIC for the illiquid fund; (B) net IRR and net MOIC for the illiquid fund; and (C) gross IRR and gross MOIC for the realized and unrealized parts of the illiquid fund’s portfolio, in each case since the inception of the fund through the end of the fiscal quarter covered by the quarterly statement. Registered investment advisers are also required to report these metrics both with and without the impact of subscription credit facilities or other similar lending arrangements. The quarterly statements for “illiquid funds” must also include reporting on contributions and distributions made by the fund.
  • Conversely, a “liquid fund” is defined as any private fund that is not an illiquid fund. Generally, most hedge funds and similar investment vehicles would fall under this category. The quarterly statements for these funds must show (A) annual net total returns for each fiscal year over the prior 10 fiscal years or since inception, whichever period is shorter; (B) average annual net total returns over the one-, five-, and 10-fiscal-year periods; and (C) the cumulative net total return for the current fiscal year as of the end of the most recent fiscal quarter covered by the quarterly statement.

Generally speaking, we believe that the Quarterly Statement rule codifies many of the best practices employed by investment advisers in the private funds industry, though certain parts of disclosure (such as the table of special fees and the requirement of lookback periods of 10 years or more in some cases) go above and beyond what even the most transparent fund managers have traditionally provided to their investors. Additionally, while the standardization of formatting for the quarterly reporting will likely please many investors looking for increased comparability of performance results across their portfolios, the Quarterly Statement Rule will almost certainly result in enhanced compliance costs for advisers – at least initially. (The Commission’s adopting release estimates that the rule will impose more than $487 million in aggregate annual costs on registered investment advisers).

While many of the PFA Rules give investment advisers an ability to seek investor approval or consent to lessen or avoid many of the SEC’s new requirements and prohibitions, the Commission specifically chose to avoid inclusion of any sort of waiver ability for the quarterly statements rule, perhaps with an eye toward how investment managers may use such an ability in negotiations with investors. The SEC disclosed on page 72 of the adopting release that “…if we were to allow investors to waive the quarterly statement requirement, then some private fund advisers may require investors to do so as a precondition to investing in a fund … [or] attempt to anchor negotiations around a waiver by including one in a private fund’s subscription agreement and thereby compelling investors to choose between expending resources to negotiate for quarterly statements or for other important terms related to fund governance and investor protection.”

Before the PFA Rules, investors in private funds often reached contractual arrangements with investment advisers or the funds themselves related to reporting. It remains to be seen how both investors and registered investment advisers will adjust their discussions on this issue under the new rules. Many large institutional investors, such as state-sponsored pension funds or university endowments, have reporting requirements mandated by statute, so there may still need to be special heightened reporting arrangements in side letters in those cases. Additionally, one might envision registered investment advisers being reluctant to agree to contractual reporting requirements that differ materially from those to which they must adhere under the PFA Rules.

As with many of the PFA Rules, the Quarterly Statement Rule represents a fundamental shift in the way that the SEC regulates the private funds industry. While the long-standing practice in the industry has been for institutional and other sophisticated investors to negotiate fund terms such as bespoke reporting requirements with fund sponsors, the Quarterly Statement Rule (along with the other PFA Rules) seem to push the regulation of private funds toward a regulatory regime that more-closely resembles the Commission’s regulation of retail investment markets.

Registered investment advisers will be required to comply with the Quarterly Statement Rule beginning on the date that is 18 months after the date of publication of the PFA Rules in the Federal Register. There is no “legacy status” or “grandfathering” of preexisting private fund arrangements, operating agreements or side letters regarding quarterly reporting.