New SEC Rules Create Additional Requirements For Investment Advisers To Private Funds – Investment Strategy

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:

• A table listing for the applicable period (1) all compensation,
  fees, and other amounts allocated or paid to the investment adviser
  or its related persons by the private fund, (2) all fees and
  expenses allocated to or paid by the private fund (other than those
  listed in (1)), and (3) the amount of any offsets or rebates
  carried forward to subsequent periods to reduce future payments or
  allocations to the adviser or its related persons (in the case of
  (1) and (2), the information must be presented both before and
  after the application of any offsets, rebates, or waivers);




• A separate table with respect to the private fund’s
  portfolio investments listing portfolio investment compensation
  paid to the adviser or its related persons by the portfolio
  investment;




• For an illiquid fund (generally, a private fund that is not
  required to redeem investors’ interests upon request and that
  provides limited opportunities for investors to withdraw), gross
  and net IRR and gross and net MOIC (multiple of invested capital)
  calculations for the fund, and a statement of contributions and
  distributions for the fund; and




• For a liquid fund (generally, a private fund that allows
  redemptions), annual net total returns for each fiscal year over
  the past 10 fiscal years or since inception (whichever is shorter),
  average annual net total returns over one-, five-, and
  10-fiscal-year periods, and the cumulative net total return for the
  current fiscal year as of the end of the most recent fiscal
  quarter.

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.

• The adviser may not charge or allocate to a private fund fees
  or expenses associated with an investigation of the adviser or its
  related persons by a governmental or regulatory authority without
  the consent of a majority in interest of unaffiliated investors in
  the fund. Notwithstanding the foregoing, the adviser may not charge
  or allocate to a private fund any fees or expenses related to an
  investigation that has resulted in sanctions on the adviser for a
  violation of the Advisers Act.




• The adviser may not charge or allocate to a private fund
  regulatory or compliance fees or expenses, or fees and expenses
  associated with an examination of the adviser or its related
  persons, unless the adviser delivers a notice of such fees and
  expenses (including the dollar amount thereof) to the investors in
  the fund within 45 days after the end of the fiscal quarter in
  which the charge is incurred.




• The adviser may not reduce a clawback payment by actual,
  potential, or hypothetical taxes applicable to the adviser, its
  related persons, and their respective interest holders, unless the
  adviser delivers a written notice to the investors in the
  applicable private fund that sets forth the dollar amount of the
  clawback payment both before and after taxes within 45 days after
  the end of the fiscal quarter in which the clawback occurs.




• When multiple vehicles advised by the adviser invest or propose
  to invest in the same portfolio investment, the adviser may not
  charge or allocate fees or expenses relating to such portfolio
  investment on a non-pro rata basis unless (1) the non-pro rata
  charge or allocation is fair and equitable under the circumstances
  and (2) prior to charging or allocating such expenses on a non-pro
  rata basis, the adviser delivers to each investor in the applicable
  private fund a written notice of the non-pro rata charge and a
  description as to how it is fair and equitable.




• The adviser may not borrow money or other assets from, or
  receive a loan or extension of credit from, a private fund it
  advises, unless the adviser (1) delivers to each investor in the
  fund a description of the material terms of the borrowing and (2)
  obtains consent from at least a majority in interest of
  unaffiliated investors in the fund.

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:

• Grant an investor in the private fund or a similar pool of
  assets the ability to redeem its interest on terms that the adviser
  reasonably expects to have a material, negative effect on other
  investors in that private fund or in a similar pool of assets,
  except:
  

  • If the ability to redeem is required by applicable laws, rules,
    regulations, or orders of any relevant government to which the
    investor, the private fund, or the similar pool of assets is
    subject; or

  
  

  • If the adviser has offered the same redemption rights to all
    other investors, and will continue to offer such rights to all
    future investors in the private fund and any similar pool of
    assets. A “similar pool of assets” is broadly defined
    under the rule and includes pooled investment vehicles managed by
    the adviser or its related persons that have substantially similar
    investment policies, objectives, or strategies as the applicable
    fund.




• Provide information about the holdings or exposures of the
  private fund or a similar pool of assets to any investor in the
  private fund if the adviser reasonably expects that providing the
  information would have a material, negative effect on other
  investors in the private fund or in a similar pool of assets,
  unless the adviser offers the information to all other existing
  investors in the private fund and any similar pool of assets at the
  same time or substantially the same time.

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:

• The adviser provides to each prospective investor, prior to
  such investor’s investment in the fund, a written notice
  with specific information regarding any preferential treatment
  related to material economic terms (such as fees, performance
  allocations, liquidity terms, and co-investment rights) provided to
  other investors in the fund; and




• The adviser delivers to each existing investor written
  disclosure of all preferential treatment that the adviser or a
  related person has provided to other investors in the fund. For an
  illiquid fund, the disclosure must be delivered as soon as
  reasonably practicable following the end of the fund’s
  fundraising period. For a liquid fund, the disclosure must be
  delivered as soon as reasonably practicable following the
  investor’s investment in the fund. An updated disclosure must
  be provided to investors at least annually if any new preferential
  terms have been granted since the last written notice.

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/h3>

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.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.