On August 23, the Securities and Exchange Commission (SEC) adopted new and amended rules (Final Rules), initially proposed last year, that will significantly increase the regulatory burden on private funds. The Final Rules retained much of the key requirements from the proposed rules, including the annual audit requirement for each private fund, preparation and distribution of detailed fund-level information in quarterly statements, fairness opinions for adviser-led secondaries, and books and records amendments. However, there are some important updates.
The Final Rules primarily address the following areas:
- Requirements to prepare and distribute quarterly statements;
- Audit requirements;
- Conditions to adviser-led secondary transactions;
- Restrictions on certain activities, including recovery of expenses and borrowing arrangements with funds; and
- Restrictions on preferential treatment of fund investors.
The Quarterly Statement Rule
The Final Rules require a registered private fund adviser to prepare and distribute a quarterly statement disclosing information on fund performance, fees and expenses, as well as certain compensation or other amounts paid to the adviser. The quarterly statements are to be sent to the fund’s investors within 45 days after the end of each of the first three calendar quarters and within 90 days after the end of each fiscal year. If the private fund is a fund of funds, then the quarterly statement must be distributed to the private fund investors within 75 days after the first three fiscal quarter ends of each fiscal year and 120 days after the fiscal year end of the private fund. Newly formed private funds will first have to comply after its second full fiscal quarter of generating operating results.
The Audit Rule
Investment advisers subject to the Audit Rule are required to obtain an annual financial statement audit of the covered private funds they advise. Any such audit must generally be performed (among other requirements): (i) by an independent public accountant that meets certain qualification requirements, including being PCAOB registered, (ii) in accordance with generally accepted accounting principles (or other comprehensive body of accounting standards that presents information substantially similar to U.S. GAAP, with any material differences reconciled), and (iii) on an annual basis. The audited financial statements of a private fund must be delivered to its investors within 120 days of the private fund’s fiscal year-end. The Adopting Release confirms that this audit requirement will be satisfied by an adviser’s compliance with its annual audit requirements under the Custody Rule but noted that “a surprise examination under the Custody Rule does not satisfy the requirements of [the Final Rules].”
Preferential Treatment Rule
Private fund advisers may not provide preferential treatment with respect to (1) certain redemptions that it expects to have a material, negative effect on other investors, unless the ability to redeem is required by law or the adviser offers the preferential redemption rights to all other investors, and (2) certain portfolio information about portfolio holdings or exposures that it expects to have a material, negative effect on other investors, unless offered to all investors. A private fund adviser may not provide preferential treatment unless certain terms are disclosed in advance of an investor’s investment in the private fund and all preferential terms are disclosed at least annually to all investors. All preferential terms must otherwise be disclosed to existing investors on an after-the-fact basis.
Adviser-Led Secondary Rule
In connection with any adviser-led secondary transaction, the Adviser-Led Secondary Rule requires covered investment advisers to distribute to investors prior to the due date of the election form for such transaction, both: (i) a fairness opinion or valuation opinion from an independent opinion provider and (ii) a written summary of any material business relationships between the adviser or its related persons and the independent opinion provider within the two-year period immediately prior to the issuance date of the fairness or valuation opinion. “Adviser-led secondary transaction” is broadly described in the Adopting Release as any transaction initiated by an adviser or its related persons that offers fund investors the option between selling all or a portion of their interests in the private fund and converting or exchanging them for new interests in another vehicle advised by the adviser or any of its related persons.
According to the SEC, the fairness or valuation opinion requirement:
- Provides an important check against a fund adviser’s conflicts of interest in structuring and leading a transaction from which it may stand to profit at the expense of private fund investors; and
- Is designed to help ensure that investors receive the benefit of an independent price assessment, which will improve their decision-making abilities and their overall confidence in the transaction.
The Adopting Release clarifies that the SEC would not view a transaction as “initiated by the adviser” if the adviser, at the unsolicited request of the investor, assists in the secondary sale of such investor’s fund interest. Further, tender offers will not be considered an adviser-led secondary transaction for the purposes of this rule if an investor is faced with the decision between: (i) selling all or a portion of its interest and (ii) converting or exchanging all or a portion of its interest.
Restricted Activities Rule
Under the Final Rules, the SEC prohibited a variety of activities. However, there are some exceptions based either on disclosure to investors, or disclosure accompanied by investor consent. The SEC provided absolute prohibitions on certain types of preferential treatment of private fund investors or investors in a “similar pool of assets” in two categories, preferential redemption rights and preferential information rights. In this regard, the SEC indicated that the new term “similar pool of assets” is intended to “capture most commonly used private fund structures (or similar arrangements) and prevent advisers from structuring around the prohibitions on preferential treatment.”
Other restricted activities include:
- Charging or allocating fees and expenses associated with an investigation of the adviser or its related persons by any governmental or regulatory authority without disclosure and consent from fund investors.
- Charging or allocating regulatory, examination, or compliance fees or expenses of the adviser, unless disclosed.
- Charging or allocating fees and 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 approach and a description of how it is fair and equitable.
- Reducing the amount of any adviser clawback for certain taxes, unless the adviser discloses the aggregate clawback before and after taxes to investors.
Compliance Date
While the Final Rules will become effective 60 days after publication in the Federal Register, the compliance dates are as follows:
- For the audit rule and quarterly statement requirement, 18 months after publication in the Federal Register.
- For the adviser-led secondaries rule, preferential treatment rule and restricted activities rule:
- 12 months after publication in the Federal Register for advisers with $1.5 billion or more in private funds assets under management; and
- 18 months after publication in the Federal Register for advisers with less than $1.5 billion in private funds assets under management.
- For the amended Advisers Act compliance rule, 60 days after publication in the Federal Register.
Takeaways and Considerations
With these sweeping changes to the regulatory landscape for the private funds industry, managers will need to review their current policies and disclosure statements to determine whether changes will need to be implemented, either as a direct requirement of the new rules, or as an industry best-practice. Investors should also be aware of these potential changes. There will certainly be industry-wide changes as a result of the implementation of these rules, and we expect additional SEC and industry guidance over the implementation period.
