The private fund industry has a new compliance hurdle to reach with the SEC’s newly adopted Private Fund Rules (“the Rules”). On August 23, 2023, the Commission voted 3-2, along party lines, to adopt new rules (a total of five) under Section 211(h) of the Advisers Act. The SEC determined that new rules were needed for the private fund industry in order to address:
- Lack of transparency in private funds
- Conflicts of interest
- Lack of governance mechanisms for private funds
The 660-page adopting release is extremely comprehensive and yet vague in certain specifics, which will make it difficult to comply with overall. The final rules, as adopted, do contain some changes from the proposed rules that are favorable to the private fund industry. This shows that the Division of Investment Management reviewed the comment letters received and considered certain changes based upon industry feedback.
Further, as an add-on to this adopting release, the SEC adopted changes to Rule 206(4)-7 to require all advisers to document the Annual Compliance Review in writing and maintain records of the review under Rule 204-2 of the Advisers Act.
Below is a broad summary of key terms and provisions in the new Private Fund Rules:
- Scope of Rules. Covers all private fund managers, both registered and unregistered investment advisers, except it will not apply to securitized asset funds such as CLO funds.
- Quarterly Statements. Private fund advisers will be required to deliver quarterly statements to all fund investors within 45 days of quarter-end in a tabular format that must include, among other items:
- The cost of investing
- Performance data
- Fees and expenses paid by the fund during the quarter
- Fees paid to the adviser by the portfolio companies during the quarter or any other compensation received
Newly formed funds must send statements after two full quarters of activity.
- Audited Financial Statements. All private funds will be required to obtain an annual audited financial statement and deliver the financials to investors within the same time frames as the Custody Rule. Certain exemptions and the use of a surprise audit are no longer applicable. Records must be kept of the investor recipients and the date sent.
- Adviser-led Secondaries. The adviser must obtain a fairness opinion or valuation opinion from an independent provider and distribute the opinion to all investors prior to election. Certain material relationship information over the past two years must be included, such as any relationship between the adviser, its related persons, and the provider of the opinion.
- Restricted Activities. Activities that were prohibited under the proposed rule are now restricted subject to disclosure and/or investor consent requirements. Examples include:
- Loan to adviser from fund – majority non-related investor consent required prior to activity
- Reducing clawbacks – disclosures must be made after the fact
- Legal/compliance costs of a regulatory investigation – consent required along with disclosures, but costs of an enforcement action cannot be borne by the funds
- Side Letters/Preferential Treatment. Special redemption rights and any other term that would have a material negative effect on other investors (i.e. preferential data regarding portfolio holdings or exposures) are prohibited unless the terms are offered to all other investors as well. Other non-material terms created by a side letter must be disclosed to other investors prior to the investment, and annually.
Importantly, the SEC has “grandfathered” the prohibitions regarding preferential treatment and certain restricted activities that require investor consent. Investor agreements prior to the compliance date will not need to be amended.
The compliance date for the new Rules are staggered based on both the size of the adviser as well as Rule provisions, so that there are different compliance dates for different parts of the new Rules. Generally, compliance dates fall within 12 to 18 months after the effective date, which is 60 days after publication in the Federal Register.
Several industry trade organizations have already filed suit against the SEC regarding the new Rules claiming the Commission has overstepped its statutory authority and violated the Administrative Procedures Act. It will be interesting to see how this plays out in the courts, but private fund managers should not wait to comply because of it, or they will find themselves flat-footed on the compliance date.
Due to the complexity of this new Rule and the many changes required for private fund managers, it is very important to first understand the new requirements and then how to implement those changes within your compliance program.