The Securities and Exchange Commission (SEC) recently proposed new rules under the Investment Advisers Act of 1940 (Advisers Act) that would fundamentally alter the disclosure and compliance obligations required of private fund advisers. KPPB LAW’s Private Fund and Capital Markets Practice Lead Raj Mahale summarizes the proposed rules below. The full SEC release and proposed rules can be found here.
Proposed Change #1 Impacting:
Detailed Accounting of All Fees and Expenses Paid by the Private Fund
The new proposed rules will require private fund advisers to include on quarterly statements:
- 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 during the reporting period (including fees paid by underlying portfolio investments);
- a detailed accounting of all fees and expenses not included in the bullet above (such as accounting, legal, audit, tax, due diligence and travel expenses reflected as separate line items on the statement); and);
- any offsets or rebates carried forward during the reporting period to reduce future payments or allocations to the adviser or its related persons. );
Advisers would also have to prominently disclose how any expenses, payments, allocations, rebates, waivers and the like are calculated, cross-referencing any relevant sections of the private fund’s organizational and offering documents that set forth the calculations.
Proposed Change #2 Impacting:
Standardized Performance Disclosures
The new proposed rules, that will require quarterly statements, include standardized performance metrics with respect to the applicable private fund. Each quarterly statement would need to include prominent disclosure of the criteria used and assumptions made when calculating these performance metrics. The exact information required to be disclosed would depend on whether the fund is defined as a liquid fund or an illiquid fund under the proposed rules. “Illiquid funds” would be defined as private funds that:
- have a limited life;
- do not continuously raise capital;
- are not required to redeem interests upon an investor’s request;
- have as a predominant operating strategy the return of the proceeds from disposition of investments to investors;
- have limited opportunities for investors to withdraw before termination of the fund; and
- do not routinely acquire as part of their investment strategy market-traded securities or derivative instruments.
- its gross and net internal rate of return and gross and net multiple of invested capital from the fund’s inception through the end of the current calendar quarter; and
- the fund’s gross internal rate of return and gross multiple of invested capital for the realized and unrealized portions of the illiquid fund’s portfolio, with the realized and unrealized performance set forth separately.
Essentially, this will require the adviser to the illiquid fund to calculate the performance measures as if the illiquid fund had called investor capital, as opposed to drawing down on any fund-level subscription facilities. In addition, any statement associated with an illiquid fund must include a summary of all contributions and distributions for the private fund.
“Liquid funds” would be defined as any private funds that are not illiquid funds. Advisers to liquid funds would be required to disclose the applicable liquid fund’s (i) performance based on its net total return on an annual basis since the fund’s inception, (ii) average annual net total returns over one, five and ten years, and (iii) cumulative net total return for the current calendar year as of the most recent calendar quarter.
Proposed Change #3 Impacting:
New Quarterly Statements Requirement
Currently, while some private fund advisers may provide periodic statements to their private fund investors, there is no regulatory requirement to do so. With the stated goal of increasing transparency to investors in private funds, the SEC has proposed a set of new, standardized disclosures that SEC-registered private fund advisers must provide to investors in quarterly statements. These quarterly statements will be required to be provided within 45 days following each calendar quarter end.
Proposed Change #4 Impacting:
Required Audits and Auditor Notification to the SEC
The SEC is also proposing that SEC-registered advisers be required to take all reasonable steps to obtain an annual audit and liquidation audit of the financial statements of the private funds they advise. The requirements associated with the proposed audit rule are very similar to those set forth in the audit requirement of the Advisers Act custody rule. However, unlike the custody rule, the proposed audit rule would prohibit advisers from satisfying the rule by obtaining a surprise examination in lieu of obtaining an audit. Under the proposed rule, audited financial statements generally would need to be prepared in accordance with U.S. Generally Accepted Accounting Principles and would have to be promptly distributed to investors. Furthermore, the written engagement agreement with the private fund auditor would have to obligate the auditor to notify the SEC (i) within four business days of its resignation or dismissal from, or other termination of, its engagement, or upon removing itself or being removed from consideration for being reappointed, and (ii) promptly upon issuing an audit report to the private fund that contains a modified opinion. The auditor would have to be an independent public accountant that meets certain standards of independence and registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board.
Proposed Change #5 Impacting:
Prohibitions on Certain Activities
The SEC is also proposing a ban on certain activities by all advisers to private funds (whether or not registered) that it deems contrary to the public interest and the protection of investors. These activities would be prohibited even if the private fund’s governing documents permit them, the adviser otherwise discloses the practices to investors or investors have expressly consented to them. The prohibited activities include:
- charging a private fund or its portfolio investments fees for underperformed services (e.g., accelerated monitoring fees);
- charging a private fund fees or expenses associated with an examination or investigation of the adviser, or regulatory and compliance fees and expenses of the adviser or its related persons;
- reducing the amount of an adviser clawback by the amount of taxes paid by the recipients of the applicable performance-based compensation;
- seeking reimbursement, indemnification, exculpation or limitation of its liability for breach of fiduciary duty (regardless of whether applicable state law would permit a waiver of fiduciary duty), willful misfeasance, bad faith, negligence or recklessness in connection with its services to the private fund;
- charging private fund fees or an expenses related to a portfolio investment (including fees and expenses related to consummated and unconsummated investments such as broken deal fees) on a non-pro rata basis across the adviser’s various funds or other advisory clients that have invested in the same portfolio investment; and
- borrowing money, securities or other fund assets, or receiving an extension of credit from a private fund client.
Proposed Change #6 Impacting:
No Preferential Treatment
The SEC is further proposing prohibiting all private fund advisers (whether or not registered) and their related persons from granting certain preferential treatment to any of their private fund investors. Private fund advisers would be prohibited from granting an investor in the private fund the ability to redeem its interests on terms that the adviser reasonably expects to have a material, negative effect on other investors in the fund. In addition, private fund advisers would be prohibited from providing information regarding portfolio holdings or exposures of the fund to any investor if the adviser reasonably expects that such information sharing would have a material, negative effect on other investors in the fund. Finally, the proposed rule would also prohibit other preferential terms unless the adviser provides written disclosures to prospective and current investors. The preferential terms would need to be described specifically to convey their relevance. These disclosures would have to be provided to prospective investors prior to their investment and annually distributed to existing investors.
Proposed Change #7 Impacting:
Annual Review of Compliance Policies and Procedures + Written Documentation
Finally, the SEC is proposing to amend the Advisers Act compliance rules to require SEC-registered advisers to document the annual review of their compliance policies and procedures in writing. Currently, the Advisers Act does not expressly require written documentation, but the SEC examination staff rely on documentation of the annual review to evaluate whether an adviser is complying with the rules and to identify weaknesses in the adviser’s compliance program. The proposed rule does not list specific items that advisers would be required to include in the written documentation and is intended to be flexible. The written documentation would have to be made available to the SEC promptly upon request. The comment period will be open for 30 days after the date of publication of the proposed rules in the Federal Register or April 11, 2022, whichever is later. Given the extensiveness of the changes set forth in these proposed rules, the SEC is proposing to provide advisers a one-year transition period to come into compliance with these rules, if they are adopted.
An Attorney Specializing in Private Equity Funds Can Help Private Fund Advisors Understand Legal Implications Related to Proposed SEC Changes to Private Fund Rules
If you are a private fund advisor interested in understanding the implications of the SEC proposed changes to private fund rules, contact Raj Mahale, private fund and capital markets attorney and partner with KPPB LAW in New York City.
Since 2003, KPPB LAW has served as a legal partner for small- to mid-size companies and guided them through a wide range of business matters, transactions and disputes. KPPB LAW is certified as a Minority Business Enterprise by the National Minority Supplier Development Council (NMSDC), AV rated by Martindale Hubbell a member of the National Association of Minority and Women Owned Law Firms. Find more information about KPPB LAW at kppblaw.com.