New SEC Rules Create Additional Requirements for Investment Advisers to Private Funds
Sep 05 2023
On August 23, 2023, the SEC adopted new rules under the Investment Advisers Act of 1940 (the “Advisers Act”). While certain of the rules apply only to SEC-registered investment advisers, others apply to all investment advisers to private funds, regardless of registration status. The new rules include (1) requirements to deliver specified information to investors on a quarterly basis, (2) a requirement that SEC-registered investment advisers cause each private fund that they advise to undergo an annual audit, (3) specific requirements for adviser-led secondary transactions, (4) restrictions on certain activities by advisers to private funds (subject to disclosure and/or consent exceptions in some cases), (5) restrictions on offering preferential redemption and information rights to fund investors (subject to certain exceptions) and a requirement to disclose all preferential terms granted, and (6) a requirement for SEC-registered investment advisers to document their annual compliance reviews in writing. Advisers registered or required to be registered with the SEC will be subject to various additional recordkeeping requirements to demonstrate compliance with the rules. This alert describes the new rules and their compliance dates in greater detail.
1. The Quarterly Statement Rule
Each investment adviser that is registered or required to be registered with the SEC must prepare a quarterly statement for any private fund advised by the adviser that has at least two fiscal quarters of operating results. Such quarterly statement must be delivered within 45 days after the end of the first three fiscal quarters of the year, and within 90 days after the end of the fiscal year. Advisers to funds of funds may deliver the quarterly statement with respect to a fund of funds within 75 days after the end of each fiscal quarter and within 120 days after the end of the fiscal year.
The quarterly statement must include:
The adviser is required to consolidate the quarterly reports of a fund with any similar pool of assets (e.g., consolidating information of a master fund and its feeder funds) if doing so would provide more meaningful information to investors and would not be misleading.
2. The Audit Rule
Each investment adviser that is registered or required to be registered with the SEC must cause each private fund that it advises (other than any securitized asset fund) to undergo an audit that meets the requirements of the “custody rule” under the Advisers Act (including that the auditor must meet independence requirements and be subject to examination by the PCAOB, and the audited financial statements must be prepared in accordance with GAAP). The adviser must deliver the audited financial statements to each investor in the applicable fund within 120 days after the end of each fiscal year and promptly upon liquidation of the fund. If the adviser is a subadviser to a private fund that the adviser does not control, the adviser must take all reasonable steps to cause the fund to undergo an audit that meets the aforementioned requirements.
While many private funds are already audited on an annual basis, funds that currently undergo a “surprise examination” in lieu of an audit in order to comply with the custody rule will need to undergo an audit to comply with the new rule.
3. The Adviser-Led Secondaries Rule
In connection with any adviser-led secondary transaction, an adviser that is registered or required to be registered with the SEC must (a) obtain and distribute to investors in the applicable private fund either a valuation opinion or a fairness opinion issued by an independent third party and (b) prepare and distribute to investors in the private fund a written summary of any material business relationships between the adviser or any of its related persons and the opinion giver within the 2-year period immediately prior to the issuance of the opinion. Such materials must be distributed to the fund’s investors prior to the due date of the election form for the applicable transaction.
An “adviser-led secondary transaction” is any transaction initiated by the investment adviser or any of its related persons that offers private fund investors the choice between: (1) selling all or a portion of their interests in the private fund and (2) converting or exchanging all or a portion of their interests in the private fund for interests in another vehicle advised by the adviser or any of its related persons. Per the rule’s authorizing release, an unsolicited request by an investor to sell its fund interest in a secondary transaction generally would not be considered an adviser-led secondary transaction. Also, tender offers generally will not fall within the rule if investors are permitted to retain their interest in the same fund with respect to the asset that is the subject of the transaction on the same terms (i.e., the investor is not required to either sell its interest or convert its interest to an interest in another vehicle as part of the transaction).
4. The Restricted Activities Rule
Any adviser to a private fund is prohibited from engaging in the following activities, subject to the exceptions described below.
As the restricted activities described above apply to all investment advisers to private funds, whether or not the adviser is registered with the SEC, exempt reporting advisers, state-registered advisers, and advisers to private funds who are not otherwise registered are required to comply with this rule.
5. The Preferential Treatment Rule
The new rules restrict advisers from granting preferential rights to investors in a private fund (subject to certain exceptions and disclosure requirements). Such rights are typically provided through side letters or similar agreements, although the rule is not limited to preferential rights granted through side letters. Under the rule, any adviser to a private fund may not:
The foregoing restrictions will not apply to contractual agreements governing a private fund that has commenced operations as of the compliance date and that were entered into in writing prior to the compliance date if the parties would be required to amend such contractual agreements in order to comply with the rule. Thus, any existing side letters or similar agreements or preferential rights set forth in a fund’s existing governing documents will not be affected by the new rules.
In addition, an adviser may not provide any preferential treatment to an investor in a private fund, unless:
This rule effectively prevents advisers and fund general partners from keeping side letter terms confidential. While redacting identifying information associated with other investors is permissible, the substantive provisions of each side letter or similar agreement will need to be disclosed to all investors in a private fund. Further, advisers will now be required to make pre-closing disclosures to prospective investors regarding material economic terms previously granted. This is a significant departure from the practices of most private funds, and advisers will need to be prepared to compile and disclose any such material economic side letter terms to subsequent closing investors before they commit to invest in the fund.
As is the case with the restricted activities rule, the preferential treatment rule applies to all investment advisers to private funds, whether or not the adviser is registered with the SEC. Thus, exempt reporting advisers, state-registered advisers, and advisers to private funds who are not otherwise registered are required to comply with these rules.
6. The Annual Review Rule
Advisers registered or required be registered with the SEC are required to review and document in writing, no less frequently than annually, the adequacy of their compliance policies and procedures and the effectiveness of their implementation. SEC-registered investment advisers are already required to review their compliance policies and procedures annually, and many advisers likely have been maintaining written documentation related thereto. To the extent an adviser is not already doing so, the adviser should be prepared to document its next annual review in writing.
7. Compliance Dates and Grandfathering
The quarterly statement rule and the audit rule will become effective 18 months after publication of the new rules in the Federal Register. The adviser-led secondaries rule, the preferential treatment rule, and the restricted activities rule will become effective (1) for advisers with $1.5 billion or more in private fund assets under management, 12 months after publication in the Federal Register, and (2) for advisers with less than $1.5 billion in private fund assets under management, 18 months after publication in the Federal Register. The annual review rule will become effective 60 days after publication in the Federal Register.
The prohibitions on (1) an adviser charging or allocating expenses associated with an investigation to a private fund without investor consent and (2) an adviser borrowing from a private fund client without investor consent will not apply with respect to contractual agreements entered into prior to the compliance date to the extent that the relevant contractual agreements would need to be amended in order to comply with the rule. Notwithstanding the foregoing, the prohibition on an adviser charging or allocating fees or expenses to a private fund related to an investigation that has resulted in sanctions on the adviser for a violation of the Advisers Act is not grandfathered, so no such costs may be charged to a private fund after the compliance date.
Also, as noted above, the prohibitions on providing preferential redemption rights and preferential information rights to certain investors will not apply to contractual agreements governing a private fund that has commenced operations as of the compliance date and that were entered into in writing prior to the compliance date if the parties would be required to amend such contractual agreements in order to comply with the rule.
Conclusion
The new rules are complex and will require changes in practices and procedures for many private funds and their investment advisers. All investment advisers (regardless of registration status) should begin preparations as soon as practicable in order to ensure that the private funds they advise will be in compliance with the new rules by the end of the applicable transition periods.