How the SEC’s Final Ruling Will Impact Investment Advisers and Private Funds
On September 14, 2023, the SEC published their final ruling, Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, on the federal register.
The publication triggered the following effective dates:
| Rule | Description | Large Private Fund Advisers | Smaller Private Fund Advisers | Applicable to Unregistered Advisers? |
|---|---|---|---|---|
| 211(h)(1)-2* | Quarterly statements | March 13, 2025 | March 13, 2025 | No |
| 206(4)-10* | Fund audit requirement | March 13, 2025 | March 13, 2025 | No |
| 211(h)(2)-1* | Restricted activities | September 13, 2024 | March 13, 2025 | Yes |
| 211(h)(2)-2* | Adviser-led secondary rule/fairness or valuation opinion | September 13, 2024 | March 13, 2025 | No |
| 211(h)(2)-3* | Preferential treatment | September 13, 2024 | March 13, 2025 | Yes |
*not applicable to Securitized Asset Fund Advisers
| Rule | Description | All Registered Investment Advisers |
|---|---|---|
| 206(4)-7 | Compliance reviews | November 13, 2023 |
1. Quarterly Statements
The ruling requires quarterly statements to be issued to investors in “clear, concise, and plain English.” For private funds, other than fund of funds, advisers are required to issue quarterly statements within 45 days of quarter end and within 90 days of year end. Advisers to fund of funds are required to issue quarterly statements within 75 days of quarter end and within 120 days of year end, and statements must detail the following:
a. Fee and expense disclosure: “Fund’s fees and expenses and any compensation paid or allocated by the fund’s underlying portfolio investments.”
i. Private fund-level: The fund level fees must be reported in a table format disclosing:
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- “A detailed accounting of all compensation, fees, and other amounts allocated or paid to the adviser, or any of its related persons by the private fund (adviser compensation) during the reporting period.”
- “A detailed accounting of all fees and expenses allocated to or paid by the private fund during the reporting period other than those listed in the paragraph above (fund expenses).”
- “The amount of any offsets or rebates carried forward during the reporting period to subsequent quarterly periods to reduce future payments or allocations to the adviser or its related persons.”
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ii. Portfolio investment-level disclosure: Advisers must disclose a detailed account of all portfolio investment compensation allocated or paid by each covered portfolio investment during the reporting period in a single table. It is important to note that the detail listing of portfolio investments and the fund’s ownership percentage of each investment as proposed was not adopted in the final rule. A “portfolio investment” includes any entity or issuer in which the fund has invested both directly and indirectly.
iii. Calculations and cross-reference to documents: The disclosure must include how the expenses were calculated. This includes performance-based calculations and the related criteria all expenses are based on, such as fixed, performance over a certain period, or value of funds’ assets. The SEC felt the investor should essentially be able to recalculate the expense. As a result, the adviser must include cross references to the relevant sections of the organizational and offering documents that stipulate the calculation methodology.
b. Performance disclosure: The adviser also must include “standardized” fund performance information. The following breaks down the performance information by fund type:
i. Liquid funds: Annual net returns for every calendar year are required from inception, average annual returns for one, five, and ten calendar year periods, and the cumulative net return for the calendar quarter.
ii. Illiquid funds: For illiquid funds, an internal rate of return (IRR) and multiple of invested capital (MOIC), including IRR and MOIC bifurcated between realized and unrealized gain/loss must be issued. Additionally, a statement of the contributions and distributions would also be required.
iii. Calculation information: To assist the investor with reperforming the calculation, the disclosure must include the criteria used and assumptions made in calculating the performance.
2. Annual Audits of Private Funds
Registered private fund advisers will need to obtain an audited set of financial statements from a Public Company Accounting Oversite Board (PCAOB) registered and inspected firm.
a. It is vital to ensure the firm you select to perform these audits are both registered AND INSPECTED. Registration with the PCAOB is one thing, but to be inspected is a significant additional burden. You must choose with care.
b. Based on Form ADV data between October 1, 2021, and September 30, 2022, there are 5,862 funds that were previously unaudited which will now be subject to audit.
Based on Form ADV data between October 1, 2021, and September 30, 2022, there are 5,862 funds that were previously unaudited which will now be subject to audit."
3. Restricted Activities
The final rule restricts advisers (both registered an unregistered) from engaging in certain activities, unless they satisfy certain disclosures, and in some cases, consent requirements, such as:
a. Investigation restriction: Charging the fund fees and expenses associated with a regulatory or governmental investigation.
b. Certain fees and expenses: Charging the fund regulatory, examination, or compliance fees of the adviser.
c. Post-tax clawback: Reducing any adviser clawback by taxes applicable to the adviser.
d. Non-pro rata restriction: Charging fees to a portfolio investment on a non-pro rata basis when the adviser invests in the portfolio company with more than one private fund.
e. Borrowing restriction: Borrowing money, securities, or other private fund assets from a private fund client.
See table below for summary of exceptions to the restrictions:
| Restricted Activity | Exemption |
|---|---|
| a) Investigation restriction | Advanced consent-based |
| b) Certain fees and expenses restriction | After-the-fact disclosure-based |
| c) Post-tax clawback restriction | After-the-fact disclosure-based |
| d) Non-pro rata restriction | Before-the-fact disclosure-based |
| e) Borrowing restriction | Advanced consent-based |
4. Adviser-led Secondaries/Issuance of Fairness or Valuation Opinion
The SEC determined that a conflict of interest exists when the adviser offers existing fund investors the option to sell or exchange their interests in the private fund for interests in another vehicle advised by the adviser (an adviser-led secondary transaction). The new rule prohibits an adviser from completing an adviser-led secondary transaction unless the adviser distributes to effected investors, prior to the closing of the transaction, either:
a. A fairness opinion stating that the price being offered to the private fund for any assets being sold is fair.
b. Or a valuation opinion stating the value of any asset being sold.
The opinions must be from an independent provider, and the adviser must include a summary of material business relationships they have or had within the past two years with the independent opinion provider.
5. Preferential Treatment
The SEC’s proposed rules over this topic were modified after addressing certain concerns raised by commenters. Exceptions to the original rules were adopted as follows. It is important to note this rule applies to both registered and unregistered advisers:
a. Prohibited preferential redemptions: This prohibits the adviser from granting an investor in the fund the ability to redeem its interest on terms that have a material, negative effect on other investors in the fund. An adviser is not prohibited from offering preferential redemption rights if:
i. Exception 1: “The investor is required to redeem due to applicable laws, rules, regulations, or orders of any relevant foreign or U.S. Government, State, or political subdivision to which the investor, private fund, or any similar pool of assets is subject.”
ii. Exception 2: “The adviser has offered the same redemption ability to all other existing investors and will continue to offer such redemption ability to all future investors in the same private fund or any similar pool of assets.”
b. Prohibited preferential transparency: The adviser may not provide information regarding the portfolio holdings or exposures of the private fund to any investor if the information would have a material, negative effect on other investors in that private fund.
i. Exception: “An adviser is not prohibited from providing preferential information if the adviser offers such information to all existing investors in the private fund and any similar pool of assets at the same time or substantially the same time.”
c. Preferential treatment and disclosure of preferential treatment:
i. The adviser is required to provide to prospective investors, prior to the investor’s investment in the fund, a written notice with specific information about any preferential treatment related to any material economic terms the adviser provides to other investors in the same fund.
ii. The adviser is required to distribute an annual written notice to current investors, which provides specific information about any new preferential treatment the adviser offers to other investors in the same private fund since the last written notice.
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- For illiquid funds, the timing of the disclosure is “as soon as reasonably practicable following the end of the fund’s fundraising period.”
- For liquid funds, the timing of the disclosure is “as soon as reasonably practicable following the investor’s investment in the private fund.”
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6. Compliance Program Review
All registered advisers, including those that do not manage private funds, must complete and document, in written format, a formal review of their compliance program.
Conclusion
The SEC’s final ruling presents significant regulations designed to protect investors who invest in private funds and can help prevent potential manipulation by investment advisers. If you are an investment adviser and need assistance understanding the impact this ruling will have on you and your funds, please reach out to a member of our team.
