Read
Analysis of the SEC’s Private Fund Adviser Rules Package
Summary:
- On August 23, 2023, the Securities and Exchange Commission adopted a new rules package focused on private funds disclosures and business practices (“PFA”). While the final rules had significant changes from the proposed 2022 rules, they will still have a material impact on private equity firms and hedge funds.
- The revised rules contain 6 key components:
1. Quarterly Fee, Expense and Performance Reporting.
2. Requirements for GP-Led Secondaries.
3. Five restricted activities and one prohibited activity.
4. Requirement for private fund audits.
5. Requirements for written annual compliance reviews.
6. Requirements around certain preferential treatment. - There are 5 material changes from the proposed rules that will make this rule much more practical and relevant:
1. For certain provisions, existing funds will be subject to grandfathering.
2. Securitized Asset Funds, including CLOs, are excluded from the provisions of the PFA.
3. The prohibition around seeking indemnity for simple negligence has been removed.
4. Other prohibited activities are now allowed with disclosure or consent.
5. Preferential liquidity is now allowed under certain circumstances.
Scope:
| Provisions | Applicability | Implementation Date | Legacy Status |
|---|---|---|---|
| Quarterly Reporting | Registered investment advisers to private funds | 18 months after publication or approximately February 2025. | None |
| GP-Led Secondaries | Registered Investment Advisers to private funds | 18-months after publication for advisers with less than $1.5 billion of AUM or approximately February 2025. 12-months after publication for advisers with more than $1.5 billion of AUM or approximately October of 2024. | None |
| Restricted Activities | Any adviser to a private fund | 18-months after publication for advisers with less than $1.5 billion of AUM or approximately February 2025. 12-months after publication for advisers with more than $1.5 billion of AUM or approximately October of 2024. | Legacy status for aspects that require consent, borrowing restrictions and charging certain investigative costs. |
| Private Fund Audits | Private funds, other than securitized asset funds (such as CLOs), managed by registered investment advisers | 18 months after publication or approximately February 2025. | None |
| Written Annual Reviews | All registered investment advisers | 60 days after publication or approximately January 2024 | None |
| Preferential Treatment | All advisers to private funds | 18-months after publication for advisers with less than $1.5 billion of AUM or approximately February 2025. 12-months after publication for advisers with more than $1.5 billion of AUM or approximately October of 2024. | Legacy status for preferential liquidity and information rights. |
Key Components and Implications:
Component 1: Quarterly Reporting
- Provisions:
| Report | Requirements |
|---|---|
| Fund-level fee/expense table, both gross and net of offsets/waiver/rebates. | Must report: 1. All compensation the fund paid or allocated to adviser/related persons during quarter (detailed by category – management, advisory, sub-advisory, perf-based comp (cash and non-cash), etc.); 2. All other fees and expenses fund paid or were allocated during period (detailed by category – org, accounting, legal, admin, audit, tax, due diligence travel, insurance); and 3. Any carry forward fee offsets/rebates that reduce adviser compensation in future periods. |
| Portfolio Investment-level fee/expense table | Must report: 1. For each portfolio investment that allocated or paid compensation to the adviser/related persons, a detailed accounting of compensation to adviser that is attributable to the fund’s interest in the investment, by category (origination, management, consulting, monitoring, servicing, transaction, admin, advisory, closing, disposition, directors, trustees’ fees), both gross and net of offsets/waivers. |
| Performance, with different categories displayed with equal prominence | 1. Liquid Funds: a) Annual net total returns since inception or 10 fiscal years prior, whichever is shorter. b) Average annual net total returns over 1-, 5- and 10- calendar years; and c) Cumulative net total returns for the current fiscal year as of quarter end 2. Illiquid Funds (performance both with and without the impact of any fund-level subscription facilities): a) Gross and net IRR since inception; b) Gross and net MOIC since inception; c) Gross IRR and gross MOIC for realized and unrealized; and d) Statement of contributions and distributions |
- Additional Provisions:
- The adviser must provide prominent disclosure of expense/payment/allocation/ waiver/offset calculation methodology and include cross-references to offering documents.
- The adviser must provide prominent disclosure of as of date and criteria/assumptions used to calculate performance.
- Catch-all categories, such as “miscellaneous” or “other” will be disallowed even for small expense items.
- The reports must be distributed within 45 days of fiscal quarter end for Q1-Q3 and within 90 days of fiscal year end. For fund of funds, within 75 days of fiscal quarter end for Q1-Q3 and within 120 days of fiscal year end.
- Analysis:
- This will be the most important and impactful provision of the rule and will take significant resources.
- The calculation of performance required under this rule may not align with the SEC’s marketing rule.
- After implementation, exams may spend significant time testing these reports.
Component 2: GP-Led Transactions
- Provisions:
- An adviser must obtain and distribute a fairness opinion or a less onerous valuation opinion from an independent party.
- The independent party must prepare and distribute a disclosure summarizing conflicts of interest.
- Tender offers, where the LP can remain in the fund, are carved out of this provision.
- Analysis:
- This provision is unlikely to materially change the risk profile or practices in the adviser-led space and is unlikely to provide investors with incremental benefits to current practice.
Component 3: Restricted Transactions
- Provisions:
| Activity | Treatment | Requirements Needed to Be Met |
|---|---|---|
| Charging costs associated with any government investigation to the fund. | Restricted | Permitted if more than 50% of non-affiliated investors consent to the charge. |
| Charging costs associated with an investigation resulting in sanctions for violating the Investment Advisers Act | Prohibited | N/A |
| Charging costs associated with regulatory compliance fees or fees pertaining to an examination. | Restricted | Distribute written notice of fees, including fee amount, to investors within 45 days after the end of the fiscal quarter. |
| Collect a clawback net of taxes | Restricted | Distribute written notice which would include the total dollar amount of clawback before and after any reduction within 45 days after the end of the fiscal quarter. |
| Collect fees or expenses related to a portfolio investment on a non-prorata basis1 | Restricted | (1) Allocation has to be fair and equitable under the circumstances. (2) Before the allocation, distribute to each investor a written notice of the allocation which describes the charge and how it is fair and equitable. |
| The adviser borrows money, securities or assets or receives a loan from a private fund client. | Restricted | (1) Distribute a notice to each investor describing the material terms of the transaction. (2) Obtain written consent from a majority of non-affiliated investors in the private funds. |
1 Where other clients or funds have invested or propose to invest in a portfolio company
- Analysis:
- The restrictions, as written, are significantly easier to implement than the prohibitions in the rule proposal.
- The requirements for the restrictions based on simple notification can be fulfilled together with the quarterly reporting requirements.
- The prohibition against seeking reimbursement for investigations resulting in sanctions under the Advisers Act could create an incentive for managers to settle under other provisions in the securities laws and therefore could reduce the number of Compliance Rule, 204A and 206(4)-8 settlements.
Component 4: Preferential Treatment
- Provisions:
| Activity | Requirements Needed to Be Met |
|---|---|
| Restrictions on preferential treatment for redemptions | An adviser may not grant preferential redemptions to investors: IF it expects the redemption to have a material negative effect on the other investors in the fund OR similar pool of assets UNLESS (a) Required by applicable law; OR (b) offered to all investors existing and future investors. |
| Prohibitions on providing preferential information | An adviser may not provide preferential information to investors: IF it expects the preferential information to have a material negative effect on the other investors in the fund OR similar pool of assets UNLESS all other existing investors in the private fund or similar pool of assets are offered the same information at substantially the same time |
- Analysis:
- Allows advisers to maintain preferential redemption for certain government agencies and allows advisers to differentiate among investors offering them different share classes with different fees/liquidity tradeoffs.
- Advisers would not be able to differentiate between investors based on investment size.
- These provisions concern primarily open-ended funds with liquid holdings.
- These provisions will have limited, if any, impact on illiquid funds.
- Provisions:
| Activity | Requirements Needed to Be Met |
|---|---|
| Disclosure of preferential treatment | An adviser must: (1) Prior to an investor’s investment in a fund, provide a written notice that provides specific information of any preferential treatment related to any material economic terms (cost of investing, liquidity rights, fee breaks and co-investment rights etc.) for any other investor in the same fund2. (2) Disclose all preferential treatments for (a) illiquid funds: at the end of the fund’s fundraising period and (b) liquid funds: after the investor has made its investment in the fund. (3) Provide an annual written notice that reflects any preferential treatments provided since the last written disclosure. |
- Analysis:
- This provision enables fund managers to distribute a record of side letter provisions and is close to the current process of implementing Most Favored Nations provisions.
2 Information in side letters that existed before the compliance date will be required to be disclosed to new investors that invest post compliance date
Component 5: Private Fund Audits
- Provisions:
- Private funds must now be audited in accordance with provisions of the Custody Rule
- Securitized Asset Funds are carved out of this requirement.
- Analysis:
- Advisers that rely on surprise exams will need to transition audits which may potentially increase costs and create operational challenges for small funds and funds created in certain jurisdictions.
Component 6: Written Annual Compliance Reviews
- Provisions:
- Registered Investment Advisers must now document their annual review in writing.
- Analysis:
- While this new requirement provides flexibility to document the written annual review in a number of ways, we believe that SEC staff will test the comprehensiveness of any written review and therefore annual review documentation should be robust.