The U.S. Securities and Exchange Commission (the “SEC”) published on February 9, 2022 a release (the “Proposing Release”) in which it proposed new rules (collectively, the “Proposed Rules”) that would apply to investment advisers to “private funds,” that is, issuers that satisfy the conditions of either exclusion from the definition of an investment company in Section 3(c)(1) or Section 3(c)(7) of the U.S. Investment Company Act of 1940, as amended (the “1940 Act”), and thus indirectly to those private funds themselves. The Proposed Rules, if adopted as proposed, would be the first significant amendments to the rules under the U.S. Investment Advisers Act of 1940, as amended (the “Advisers Act”), that apply to investment advisers that manage private funds since the rules adopted in 2011 and 2012 under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”).[1]

The purposes of the Proposed Rules, as stated in the Proposing Release, are to (a) promote transparency, especially as it relates to private fund expenses, performance, and preferential terms given to some investors but not others, and (b) eliminate or manage certain conflicts of interest of private fund investment advisers that may not be transparent to investors, especially in adviser-led secondary transactions. Whereas all of the Proposed Rules would apply to registered investment advisers to private funds (“registered private fund advisers”), only those Proposed Rules that prohibit certain activities would apply to “exempt reporting advisers” to private funds.[2] In addition, all registered investment advisers, including registered investment advisers to clients other than private funds, would be required to document in writing their annual review of their compliance policies and procedures.

The period for public comments to the Proposed Rules ends 30 days following publication of the Proposing Release in the Federal Register, or April 11, 2022, whichever is later. As of the date of this Client Alert, the Proposing Release had not been published in the Federal Register.

Summary of the Proposed Rules

The Proposed Rules comprise five principal sections: a new requirement to provide fund investors with quarterly statements relating to fund fees and expenses as well as fund performance; a requirement that all funds provide investors audited annual financial statements and audited financial statements at liquidation; new rules relating to adviser-led secondary transactions; newly articulated prohibitions of certain investment adviser activities relating to their managed private funds; and new prohibitions and disclosure obligations relating to preferential treatment provided to some private fund investors but not all. Below are brief summaries of those principal sections of the Proposed Rules.

• Quarterly Statements - A registered private fund adviser would be required to provide the investors of a managed private fund a statement each quarter with the following information:
  • Amounts of all fees and expenses paid by the private fund during the reporting period, which must be presented by types of fees and expenses and must be segregated between amounts paid to the investment adviser and its related persons[3] and amounts paid to third-party service providers.
  • Amounts of compensation and other fees paid by the private fund’s portfolio investments during the reporting period to the investment adviser and its related persons.
  • Performance information based on whether the private fund is an “illiquid fund,” that is, a private fund that does not provide periodic liquidity, other than in exceptional circumstances, or a “liquid fund,” that is, a private fund other than an illiquid fund. (Many private equity, real estate and venture capital funds likely would be categorized as illiquid funds; many hedge funds likely would be categorized as liquid funds.)
  • Illiquid funds would be required to present gross and net internal rates of return and gross and net multiples of invested capital, and information would be included to capture performance through the end of the current calendar quarter.
  • Liquid funds would be required to provide annual net total returns since inception, average annual net total returns over specifically prescribed time periods (generally, 1-, 3-, 5- and 10-years), and quarterly net total returns for the current quarterly reporting period.
  • An adviser would be required to maintain a record of its determination of whether a private fund is an illiquid or a liquid fund as part of its books and records pursuant to Section 204-2 under the Advisers Act.
• Mandatory Private Fund Audits - A registered private fund adviser would be required to cause each of its private funds to prepare and send to the private fund’s investors audited financial statements at least annually and at liquidation. Currently, a registered private fund adviser only is required to provide audited financial statements if the adviser has custody of fund assets, as provided in Rule 206(4)-2 under the Advisers Act.
  
  Similar to Rule 206(4)-2, the auditor performing the audit would be required to register with the Public Company Accounting Oversight Board (PCAOB), and the audited financial statements must be prepared in accordance with U.S. generally accepted accounting principles (US GAAP) or, for non-U.S. funds (or where the fund has a non-U.S. general partner), they must contain information substantially similar to financial statements prepared in accordance with US GAAP, with a reconciliation of material differences.
  
  One difference between the custody rule and the Proposed Rules is that under the Proposed Rules, there must be a written agreement among the adviser, the private fund, and the auditor pursuant to which the auditor would be required to notify the SEC in the event it engagement as auditor is terminated or it issues a modified opinion (i.e., a qualified opinion, an adverse opinion, or a disclaimer of opinion).
  
  Another difference is the timing of delivery of the audited financial statements to investors. Rule 206(4)-2 requires that audited financial statements be provided within 120 days of the period end, and the SEC Staff permits 180 days in the case of funds of funds. In contrast, the Proposed Rules only require that the audited financial statements be provided “promptly” after completion. That said, the Proposing Release notes that the 120-day standard is generally appropriate, but it recognizes that there may be times when unforeseeable circumstances make it impractical.
  
  Finally, unlike Rule 206(4)-2, the Proposed Rules do not provide the registered investment adviser with the option of electing a surprise examination of the private fund’s portfolio assets in lieu of audited annual financial statements.
• Adviser-Led Secondary Transactions - A registered investment adviser would be required in connection with a secondary transaction led by the investment adviser, to cause its managed private funds to obtain and deliver to investors prior to the transaction a fairness opinion from an independent third party. Secondary transactions would include transactions when an investment adviser offers existing private fund investors the option to sell their private fund interests, including to new investors, or when existing private fund investors are invited to exchange their fund interests for interests of another fund managed by the adviser. The Proposed Rules would require the opinion provider to opine on the fairness of the price being offered for any assets being sold as part of the transaction. The Proposing Release asks for comments on whether the opinion should be broader and cover all or certain terms of a transaction.
• Prohibited Activities - An investment adviser, whether registered with the SEC or filing notices with the SEC as an exempt reporting adviser, would be prohibited from engaging in any of the following activities:
  • Charging a private fund fees for services that the investment adviser does not, and does not reasonably expect to, provide to the fund’s portfolio investments. For example, an adviser would not be permitted to collect the unpaid portion of a fee to pay for the ongoing monitoring of a portfolio investment upon the occurrence of the sale of the portfolio investment if, as a result of the sale, the adviser would never provide the ongoing future monitoring.
    
    Charging a private fund for the investment adviser’s fees and expenses associated with an examination or investigation of the investment adviser or its related persons by any governmental or regulatory authority, or the regulatory or compliance fees of the adviser or its related persons, even if such fees and expenses are disclosed to fund investors.
  • Reducing the amount of any “clawback” from the adviser or its related persons by any actual, potential, or hypothetical taxes applicable to the adviser or its related persons or their respective owners or interest holders. The Proposed Rules define an adviser clawback as any obligation of the investment adviser or its related persons or their respective owners or interest holders to restore or otherwise return performance-based compensation to the private fund pursuant to the private fund’s governing agreements.
  • Seeking reimbursement, indemnification, exculpation, or a limitation of the adviser’s liability for a breach of fiduciary duty, willful misfeasance, bad faith, negligence, or recklessness in providing services to the private fund, even if such terms would be permissible under state or other laws.
  • Charging or allocating fees and expenses relating to a private fund’s portfolio investment (or potential portfolio investment), directly or indirectly, on a non-pro rata basis when multiple private funds and other clients advised by the investment adviser or its related persons have invested or propose to invest in the same portfolio investment.
  • Borrowing money, securities, or other fund assets, or receiving a loan or an extension of credit, from a private fund client, even if the practice were disclosed or approved by a limited partner advisory committee (LPAC). It would not prevent, however, the adviser from borrowing from a third party on a fund’s behalf or from lending to the fund on interest rates that are not excessive or terms that are abusive.
• Preferential Treatment - An investment adviser, whether registered with the SEC or filing notices with the SEC as an exempt reporting adviser, and its related persons would be prohibited from providing to certain investors preferential redemption or withdrawal rights or information about the fund’s portfolio holdings or investment exposures, even if disclosed to all current and prospective investors. The adviser and its related persons also would be prohibited from providing other preferential treatment to certain investors unless disclosed to current and prospective investors. The term “preferential treatment” is not defined in the Proposing Release, and according to the Proposing Release, whether terms were preferential would depend on the facts and circumstances. Under the Proposed Rule, an adviser would need to describe specifically the preferential treatment. The Proposing Release provides as an example that “mere disclosure that some investors pay a lower fee is [not] specific enough;” that adequate disclosure would be to describe the alternative fee arrangement or a range of applicate fee rates.

Other Proposed Rule Provisions

The Proposed Rules also include amendments to Rule 204-2 under the Advisers Act, which requires all registered investment advisers to maintain certain books and records. The amended rules generally would require registered investment advisers to maintain adequate records to support their compliance with the Proposed Rules.

The Proposed Rules also include an amendment to Rule 206(4)-7, which requires registered investment advisers to maintain certain compliance policies and procedures. Pursuant to the Proposed Rules, all registered investment advisers, not just those registered investment advisers to private funds, would be required to review and document in writing, no less frequently than annually, the adequacy of its compliance policies and procedures and the effectiveness of their implementation.

[1] 124 Stat. 1376-2223 (July 21, 2010). The SEC has adopted final rules for 67 rulemaking provisions of the Dodd-Frank Act, including eight rules specific to private funds and their investment advisers. Of the rules specific to private funds, the last was adopted in February 2012.

[2] “Exempt reporting advisers” are investment advisers that are exempt from registering with the SEC but which file reports with the SEC, primarily Form ADV, Part 1A. There are two types of exempt reporting advisers. First, there are those investment advisers that provide investment advice only to private funds under Advisers Act Section 203(m) and which have less than $150 million in assets under management. Second, there are those investment advisers that provide investment advice only to “venture capital funds” under Advisers Act Section 203(l) - generally, to private funds that meet certain conditions relating to their investments as well as other funds that invest in securities issued by small businesses - and which have less than $250 million in assets under management. Those rules are applied slightly differently to non-U.S. investment advisers serving funds with U.S. investors.

[3] The Proposed Rules define a “related person” to include (a) all officers, partners, or directors (or any person performing similar functions) of the adviser, (b) all persons directly or indirectly controlling or controlled by the adviser, (c) all current employees (other than employees performing only clerical, administrative, support or similar functions) of the adviser; and (d) any person under common control with the adviser. The term “control” would be defined to mean the power, directly or indirectly, to direct the management or policies of a person, whether through ownership of securities, by contract, or otherwise. These definitions are substantially similar to the corresponding definitions used in Form ADV and in Rule 206(4)-2.