The adopting release describes the increasing importance of private funds and their advisers to investors, noting that there are now over 5,000 registered private fund advisers holding over $25 trillion in private fund assets under management. The adopting release outlines the SEC’s view that there are three primary factors that contribute to investor protection risks and harms: lack of transparency, conflicts of interest and lack of effective governance mechanisms for client disclosure, consent, and oversight. It adds that the SEC has pursued enforcement actions against advisers for fraudulent practices related to fee and expense charges or allocations that are influenced by the advisers’ conflicts of interest. According to the adopting release, despite the SEC’s examination and enforcement efforts, problematic practices persist, necessitating new rules to protect investors, promote efficient capital markets and encourage capital formation.
In an August 23, 2023 (the adopting release), the Securities and Exchange Commission (SEC) voted to adopt long-awaited new rules and amendments under the Investment Advisers Act of 1940 (the Advisers Act) (the Rule). The Rule’s effective date is November 13, 2023, with varying compliance dates described below:
- The compliance date for the amendment to the compliance rule under the Advisers Act (as discussed under “Key takeaways” below) is November 13, 2023.
- For the requirements regarding adviser-led secondary transactions, restricted activities, and preferential treatment (as discussed under “Adviser-led secondaries,” “Restricted activities” and “Preferential treatment/side letters,” respectively, below), the compliance dates are: (a) for advisers with $1.5 billion or more in private fund assets under management, September 14, 2024, and (b) for advisers with less than $1.5 billion in private fund assets under management, March 14, 2025.
- The compliance date for the quarterly statement and private fund audit requirements (as discussed under “Quarterly statements” and “Mandatory private fund audits,” respectively, below) is March 14, 2025.
The SEC noted that the Rule is designed in part to increase investors’ visibility into certain adviser practices, but also to address adviser practices that can potentially lead to investor harm. As adopted, the Rule significantly increases regulatory compliance obligations of private fund advisers.
For example, the Rule prohibits private fund advisers, including unregistered advisers, from providing preferential redemption terms or certain information about portfolio holdings or exposures to any private fund investor if the adviser reasonably expects that providing the information would have a material, negative effect on other investors in that private fund or in a similar pool of assets, in each case, subject to certain exceptions.
The Rule also restricts (rather than strictly prohibits, as originally proposed) private fund advisers, including unregistered advisers, from engaging in certain activities and practices, unless they satisfy specific disclosure and, in some cases, consent requirements. These practices include (i) charging or allocating certain fees or expenses on a non-pro rata basis, (ii) reducing the amount of any adviser claw back by the amount of certain taxes, (iii) charging certain regulatory, compliance, examination and investigation fees and expenses of the adviser or its related persons and (iv) borrowing fund assets or receiving an extension of credit from private fund clients.
According to the adopting release, the SEC believes that these activities and practices involve conflicts of interest and compensation schemes that are “contrary to the public interest and the protection of investors.” However, the SEC believes that the protective restrictions as adopted are reasonably designed to prevent fraud and deception.
In addition to amending the books and records and compliance rules under the Advisers Act, the Rule also requires registered private fund advisers to:
- Provide investors with quarterly statements to increase transparency regarding the full cost of investing in private funds and the performance of such funds;
- Obtain a financial statement audit by an independent public accountant for each private fund at least annually and upon liquidation, and distribute such audited financial statements to investors; and
- Obtain and distribute to investors either a fairness opinion or a valuation opinion from an independent opinion provider in connection with certain adviser-led secondary transactions where such adviser offers fund investors the option to (x) sell their interests in the private fund or (y) exchange them for new interests in another vehicle advised by the adviser.
The new rules and amendments contained in the adopting release are discussed in greater detail below. Some key takeaways of the Rule include:
- Rules requiring registered private fund advisers to (i) obtain and distribute to investors annual, audited financial statements prepared by independent public accountants, (ii) obtain and disclose to investors a fairness opinion or a valuation opinion from an independent opinion provider in connection with certain adviser-led secondary transactions and (iii) provide investors with quarterly statements that disclose detail on fund fees, expenses, and performance.
- Rules restricting all advisers of private funds (including unregistered advisers) from (i) charging or allocating certain fees or expenses on a non-pro rata basis, (ii) reducing the amount of any adviser claw back by the amount of certain taxes, (iii) charging certain regulatory, compliance, examination and investigation fees and expenses and (iv) borrowing fund assets or receiving an extension of credit from private fund clients.
- Rules prohibiting all advisers of private funds from providing certain preferential redemption and information rights.
- An amendment of the books and records rule under the Advisers Act, requiring advisers to retain records related to the Rule.
- An amendment of the compliance rule under the Advisers Act such that all registered investment advisers would be required to document their annual review in writing. The SEC did not prescribe any elements regarding what must be a part of the written review and intends for advisers to have flexibility with respect to how they satisfy this requirement.
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