SEC Rules Impose New Disclosure and Audit Requirements on Private Fund Advisers – What You Need to Know

On August 23, 2023, the SEC approved final rules imposing stricter requirements – including new client disclosures and audit requirements – on private fund advisers. The rules will take effect on a staggered schedule, with some being effective 60 days after publication in the Federal Register, and others further out.

Among other requirements, the rules will require private fund advisers who are registered with the SEC to:

• Provide to fund investors quarterly statements with detailed information about fund performance, fees and expenses.
• Obtain an annual audit for each private fund.
• Obtain a fairness opinion or valuation opinion in connection with an adviser-led secondary transaction.

The new rules also restrict other activities by all fund advisers – not just advisers registered with the SEC – that the SEC deems contrary to the public interest. These activities include:

• Charging or allocating to the private fund fees or expenses associated with the investigation of the adviser without disclosure and consent from fund investors.
• Charging or allocating to the private fund fees to cover adviser expenses for examination or compliance costs, unless the fees and expenses are disclosed to investors.

In its release detailing the reforms, the SEC explained the rationale for the new rules in part by noting that private funds and their advisers play an increasingly important role in the lives of millions of Americans planning for retirement, since “public and private pension plans, endowments, foundations and certain other retirement plans…all invest directly in private funds.”

Rule Details for Registered Fund Advisers

Specifically, the new rules for registered fund advisers include:

Quarterly Statement Rule. The reforms require registered private fund advisers to distribute a quarterly statement to private fund investors. The statement must disclose fund-level information regarding performance, the cost of investing in the private fund, fees and expenses paid by the private fund, as well as certain compensation and other amounts paid to the adviser.

Private Fund Audit Rule. The reforms require registered private fund advisers to ensure that 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 will provide an important check on the adviser’s valuation of private fund assets and protect private fund investors against the misappropriation of fund assets.

Adviser-Led Secondaries Rule. The reforms require a registered private fund adviser to obtain a fairness opinion or a valuation opinion 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 has, or has had within the prior two years, with the independent opinion provider. This requirement will provide a check against an adviser’s conflicts of interest in structuring and leading such transactions.

Books and Records Rule Amendments. To facilitate the SEC’s ability to assess an adviser’s compliance with the rules, the reforms include amendments to the books and records rule under the Advisers Act for registered private fund advisers.

Rule Details for All Private Fund Advisers

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 all private fund advisers from engaging in the following activities that are contrary to the public interest and the protection of investors:

• Charging or allocating to the private fund fees or expenses associated with an investigation of the adviser without disclosure and consent from fund investors. 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;
• Reducing the amount of an adviser clawback by the amount of certain taxes, unless the adviser discloses the pre-tax and post-tax amount of the clawback to investors;
• 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 non-pro rata 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 client without disclosure to, and consent from, fund investors.

Preferential Treatment and Restrictions on Side Letters Rule. To address the material, negative effects of specific types of preferential treatment on other investors, the reforms prohibit all private fund advisers from providing preferential terms to investors regarding: a) 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 b) certain preferential information about portfolio holdings or exposures, unless such preferential information is offered to all investors. In addition, this rule prohibits all private fund advisers from providing preferential treatment to investors, unless certain terms are disclosed in advance of an investor’s investment in the private fund and all terms are disclosed after the investor’s investment.

Legacy Status. The SEC will provide legacy status for the prohibitions aspect of the Preferential Treatment Rule 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 requires the parties to amend the agreements.

Rule Details 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 Commission to determine advisers’ compliance with the rules and identify potential compliance program weaknesses.

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, which generally include Collateralized Loan Obligations, they advise.

Rationale for New Rules

In its release detailing the reforms, the SEC explained the rationale for the new rules by noting that private fund assets under management have increased over the past decade from $9.8 trillion in 2012 to $26.6 trillion in 2022, and the number of private funds has more than tripled.

Additionally, private funds and their advisers play an increasingly important role in the lives of millions of Americans planning for retirement. While private funds typically issue their securities only to certain qualified investors, such as institutions and high net worth individuals, individuals have indirect exposure to private funds through those individuals’ participation in public and private pension plans, endowments, foundations and certain other retirement plans, which all invest directly in private funds.

Compliance Schedule

The new rules will become effective 60 days after publication in the Federal Register, and compliance dates are:

• For the Private Fund Audit Rule and the Quarterly Statement Rule, the compliance date will be 18 months after the date of publication in the Federal Register.
• For the Adviser-Led Secondaries Rule, the Preferential Treatment Rule, and the Restricted Activities Rule, the SEC is considering staggered compliance dates for advisers based on private fund assets under management.
• Compliance with the amended Advisers Act compliance rule will be required 60 days after publication in the Federal Register.

How Anchin Can Help

Anchin’s Financial Services Group can provide additional insight into the SEC’s newly adopted rules for private fund advisers. We will keep you updated on publication dates in the Federal Register so that you can be sure to keep on track with compliance requirements. For further information on how these requirements will affect you, please reach out to Ed Thorp, David Horton or your Anchin Relationship Partner.