The following is the first in a series of Alerts by Duane Morris on the August 23, 2023, approval by the U.S. Securities and Exchange Commission (SEC) of new rules applicable to private fund advisers under the Investment Advisers Act of 1940. Here, we provide an overview of the new rules, and each subsequent part in the series will break out an essential element of the rules and offer a more extensive analysis.

When the SEC initially proposed the rules, the industry reacted strongly, providing thousands of comments, some of which were lengthy and detailed. Specifically, this response came because the rules promised to fundamentally alter the way in which business is conducted by private fund advisers including, in certain material respects, exempt reporting advisers (ERAs).

The SEC heard this feedback, as evidenced in the discourse among commissioners and the fact that the final rules adopted by a split commission (via a 3-2 vote) were less burdensome and imposing than originally presented. This is not to say the commission pulled back on its core objective to "reform" the industry and materially impact adviser practices, but it did acknowledge and seek to address the most serious concerns of commenters. Nowhere is that more apparent than with the fact that the SEC omitted from the proposed rules a mandate on the adviser's standard of care under fund agreements. Below we provide a high-level review of the final rules as adopted, with some exceptions noted below.

Summary of the New Requirements

The final rules will require private fund advisers registered with the SEC to provide investors with (i) quarterly statements detailing specific information regarding private fund fees, expenses and performance; (ii) an annual financial statement audit of each private fund it advises; and (iii) a fairness or valuation opinion from an independent provider covering adviser-led secondary transactions.

The final rules will prohibit fund advisers from providing investors with preferential treatment related to (i) redemptions and (ii) information about portfolio holdings or exposures if the treatment will have a material and negative effect on other investors. Otherwise, advisers can provide such treatment after making certain disclosures to all current and prospective investors. This is a departure from the SEC's original plans to heavily regulate side letters that have the effect of granting preferential terms to early stage and large investors.

Additionally, the final rules define and limit "restricted activity" from advisers that is contrary to the public interest and protection of investors. Broadly speaking, this means that advisers cannot engage in certain restricted activities unless they provide appropriate disclosures and, in certain cases, obtain investor consent. Of note, in the initial proposal, the SEC sought to bar private funds from charging investors to cover regulatory compliance expenses and the costs of government investigations. However, under the final rules, this is a permissible fund expense with appropriate disclosures and consent. Private fund advisers will not be permitted, however, to charge or allocate certain investigation costs to the fund where there is a sanction for a violation of the Advisers Act.

The SEC also adopted grandfathering provisions for certain preferential treatment and restricted activities to prevent the need for advisers to renegotiate governing agreements for existing funds. This legacy status will only apply to governing agreements entered into in writing prior to the compliance date of the final rules and for funds that already commenced operations as of the compliance date.

Lastly, the final rules will require all registered advisers, including those that do not advise private funds, to document in writing an annual review of compliance policies and their implementation.

As noted, the SEC abandoned certain prohibitions from the initial proposal due to widespread industry pushback. For example, the SEC pulled back its prohibitions on private fund advisers' ability to charge fees for unperformed services, e.g., accelerated monitoring fees, and from seeking indemnification from investors if they are found negligent in certain situations since, as the SEC contended, these types of activities already violate an adviser's fiduciary duty under the Advisers Act.

Compliance with the amended compliance rules under the Advisers Act will most likely be required by November 2023, or 60 days after the date of publication in the Federal Register. Advisers will be given an 18-month transition period for the final rules related to the annual financial statement audit and distribution of quarterly statements, or approximately March 2025.

The SEC has adopted staggered compliance dates for the adviser-led secondaries rule, the preferential treatment rule and the restricted activities rule as follows:

  • 12-month transition period, or approximately September 2024, for advisers with $1.5 billion or more in private funds assets under management.
  • 18-month transition period, or approximately March 2025, for advisers with less than $1.5 billion in private funds assets under management.

A Closer Look at What Is Required

The following is a closer look at the final rules and their impact on private funds and their advisers.

Registered Private Fund Advisers

  • Quarterly Statement Rule. The final rules will require registered private fund advisers to provide a quarterly statement to private fund investors disclosing (i) fund-level information regarding fund performance; (ii) in a prominent manner, the costs associated with investing in the private fund; (iii) fees and expenses paid by the private fund; and (iv) compensation and other amounts paid to the adviser. The quarterly statements must include cross references to the sections of the private fund's organizational and offering documents that set forth the applicable calculation methodology. These requirements are not applicable to ERAs or state-registered advisers.
  • Private Fund Audit Rule.The final rules will require registered private fund advisers to cause the private funds they advise to undergo a financial statement audit that meets the requirements of the audit provision in the Advisers Act custody rule (rule 206(4)-2)). These audits are intended to provide a check on the adviser's valuation of private fund assets and protect private fund investors against the misappropriation of fund assets. This requirement is not applicable to ERAs?although many ERAs already obtain audits?or state-registered advisers.
  • Adviser-Led Secondaries. The final rules will require a registered private fund adviser to obtain a fairness opinion or a valuation opinion from an independent provider 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. The rule also requires the adviser to prepare and distribute to the private fund's investors a summary of any material business relationships the adviser or any of its related persons has, or has had within the prior two years, with the independent opinion provider. This requirement is intended to provide a check against an adviser's conflicts of interest in structuring and leading such transactions. This requirement is not applicable to ERAs or state-registered advisers.

All Private Fund Advisers (Including ERAs)

  • 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 (but does not "prohibit" as originally intended) all private fund advisers, including ERAs, from engaging in the following activities:
    • Charging or allocating to the private fund fees or expenses associated with an investigation of the adviser without disclosure and consent from at least a majority in interest of the fund investors that are not related persons. Further, 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 Advisers Act or the rules promulgated thereunder;
    • Charging or allocating to the private fund regulatory, examination or compliance fees or expenses of the adviser, unless such fees and expenses are disclosed to investors in writing at least 45 days after the end of the fiscal quarter in which the charge occurs;
    • Reducing the amount of an adviser clawback by the amount of actual potential or hypothetical taxes applicable to the adviser, its related persons or their respective owners or interest holders, unless the adviser 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 fees or expenses related to a portfolio investment on a non-pro rata basis, unless the allocation approach is fair and equitable and the adviser distributes advance written notice of the 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 investor without disclosure of the material terms to a majority in interest of the private fund's investors and without receiving consent therefrom.
  • Preferential Treatment Rule. The final rules prohibit all private fund advisers, including ERAs, from directly or indirectly providing preferential terms to investors. The adviser reasonably expects to have a material, negative effect on other investors in the private fund regarding: (i) 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; and (ii) certain preferential information about portfolio holdings or exposures, unless such preferential information is offered to all investors.

In addition, advisers must distribute to current investors in an illiquid fund a written disclosure of all preferential treatment the adviser has provided to others in the same fund as reasonably practicable following the end of the private fund's fundraising period. For a liquid fund, a written disclosure must be provided as soon as reasonably practicable following the investor's investment in the private fund. Annually, the private fund must provide a written notice that provides specific information regarding any preferential treatment provided by the adviser or its related persons to other investors in the same private fund since the last written notice.

  • Legacy Status. The SEC is providing legacy status for the prohibitive aspects of the preferential treatment rule (such as prohibiting advisers from providing certain preferential redemption rights and information about portfolio holdings) 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 now amend the agreements.

The quarterly statement rule, private fund audit rule, adviser-led secondaries rule, restricted activities rule and preferential treatment rule do not apply to investment advisers with respect to securitized asset funds they advise.

For All Registered Advisers

  • Compliance Rule Amendments. The reforms include amendments to the compliance rule under the Advisers Act requiring all registered advisers, including those that do not advise 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 to determine adviser compliance with the rules and identify potential compliance program weaknesses.

Books and Records Rule

The final rules also include amendments to the books and records rules under the Advisers Act for all advisers registered or required to be registered with the SEC, i.e., ERAs, in order to enable the SEC to assess an adviser's compliance with the final rules.

We will continue our review of final rules and will provide a deeper analysis over the next few weeks.

For More Information

If you have any questions about this Alert, please contact Nicholas Stewart, Trina L. Glass, David A. Sussman, Richard Charles "Chuck" Miller, Michael C. Hardy, Nanette C. Heide, any of the attorneys in our Investment Funds Group or the attorney in the firm with whom you are regularly in contact.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.