New Private Funds Rule Proposal

Summary:

• On 2/9/2022 the Commission proposed a new rule focused on private funds disclosure and business practices.
• The rule has 6 components:
  • New quarterly reporting requirements;
  • New mandate for private requirements for private fund audits;
  • New independent fairness opinion for GP‐Led transactions;
  • A list of 6 newly prohibited activities;
  • New requirements about potential preferential treatment; and
  • A requirement to document the annual 206(4)‐7 review in writing.
• This rule proposal is very broadly drafted, which may create unintended consequences.  Because of this, we believe that this rule proposal will likely be substantially modified after comment.

Key Components and Implications:

• Component 1: Quarterly Reports
  • An investment adviser must prepare a quarterly statement that includes certain information regarding fees, expenses, and performance and distribute the quarterly statement to the private fund’s investors within 45 days after each calendar quarter.  The quarterly statements would have the following components:
    • Fund Level Disclosure:  The adviser would be required to show a table itemizing each type of fund fee or expense.  This includes expenses paid to related persons and expenses such as organizational, accounting, legal, administration, audit, tax, due diligence, and travel expenses.  The rule release specifically identifies fees and expenses incurred in vertically integrated managers as being eligible for disclosure under this provision.
    • Portfolio Level Disclosure: The adviser would be required to show a table itemizing portfolio level fees and expenses on separate line items including fees such as origination, management, consulting, monitoring, servicing, transaction, administrative, advisory, closing, disposition, and directors’ compensation.  The rule defines “covered” portfolio investments to ensure that the disclosure is meaningful, but Page 1 further requires the manager to calculate the imputed costs to the fund holding the investment via its ownership percentage.
    • Ownership Percentage: The adviser would need to disclose each fund’s ownership percentage in each portfolio holding.
  • The adviser would also need to provide additional information about the form of fee calculations and the disclosure in its documents authorizing its fee practices.
    • Analysis: While there is some ambiguity around the exact categories of fees, most fund managers have the data to create the reports required under this section of the rule.  This will require more accounting resources and create more regulatory risk associated with incorrectly presenting a large volume of data.  If implemented, this type of disclosure may also stress investor relations teams who will have to explain the disclosure to investors, not all of whom may be used to receiving this much information.  It is likely, however, that this type of disclosure will put pressure on manager fees and expenses, however it is also likely that the private funds industry will not have enough uniformity in their reporting practices to give complete transparency.

• Component 2:  Enhanced Performance Disclosure
  • Fund managers will need to disclose their performance on a quarterly basis in a standardized manner depending on whether a fund is Liquid or Illiquid, as defined by the rule.
    • Liquid Funds: Liquid funds would need to disclose (1) annual net returns for each calendar year since inception; (2) average annual net total return over a one‐, five‐, and ten calendar year period; and (3) cumulative net total return for the current calendar year as of the end of the most recent calendar quarter covered by the quarterly statement.
    • llliquid Funds: Illiquid funds would need to disclose (1) gross internal rate of return and gross multiple of invested capital; (2) net internal rate of return and net multiple of invested capital; (3) gross internal rate of return and gross multiple of invested capital for both the realized and unrealized portions shown separately.  All returns would be calculated since each fund’s inception net of any subscription line of credit.  Illiquid funds would also need to provide a statement of contributions and distributions.
      • Analysis: The rule is very prescriptive around performance representation and carefully defines all terms which may be relevant.  Since these metrics are strictly defined, scrutinizing these areas and finding mistakes will be easier for examiners.  This also creates additional pressure on interim valuations for illiquid holdings and on getting timely data from portfolio companies.

• Component 3: Mandatory Fund Adviser Audits
  • All registered investment advisers must obtain fund audits and provide reconciliation to US GAAP.  The auditor must notify the Commission upon certain events.  The proposal also requires a liquidation audit to be performed.
    • Analysis: The component of the proposal is unlikely to be controversial as most managers already audit their funds.  One key important modification here is the requirement for auditors to notify regulators upon certain events.  This could significantly help the SEC’s enforcement efforts, as it was rare for auditors to notify the SEC of issues.

• Component 4: Adviser‐Led Secondaries
  • The proposal would require managers to obtain fairness opinions as part of any GP‐Led secondary process.  The fairness opinion provider would need to make detailed conflicts disclosures as part of issuing the opinion.
    • Analysis: The GP‐Led industry has already begun to trend towards obtaining fairness opinions on GP‐Led transactions.  This rule would codify this requirement.  This rule also highlights the intense regulatory scrutiny of these types of transactions.

• Component 5: Prohibitions
  • The proposal would prohibit the following:
    • Fees for Unperformed Services: The proposal would prohibit managers from receiving compensation for monitoring, servicing, consulting, or other fees in respect to any services that the investment adviser does not, or does not reasonably expect to, provide.
      • Analysis: This prohibition appears to be targeted at accelerated monitoring fees, but is broadly enough written that it could also capture allocation of service costs that are based on metrics other than time allocation.  This could be challenging to implement if a time tracking system is not already in place.
    • Compliance Costs: The proposal would prevent an adviser from charging a private fund for fees or expenses associated with an examination or investigation of the adviser or its related persons by any governmental or regulatory authority, as well as regulatory and compliance fees and expenses.
      • Analysis: This is already standard practice at many investment managers.
    • Clawbacks: The proposal would prevent an adviser reducing an actual or potential clawback by applicable taxes.
      • Analysis: Clawback reduction has been a frequent investor complaint, and although rising markets have created an environment where clawbacks have Page 3 become rare, clawbacks may again become an issue if the financial markets turn.  This part of the proposal would make American waterfalls relatively less attractive and may slow the collection of carried interest by managers.
    • Limits to Fund Indemnification: The proposal would prevent an adviser from seeking indemnification from its funds in cases of a breach of fiduciary duty, willful malfeasance, bad faith, negligence, or recklessness in providing services to the private fund.
      • Analysis: This provision refers specifically to hedge clauses which limit an adviser’s fiduciary duty under certain state law.  This particular prohibition has been a top priority for the Institutional Limited Partners Association.
    • Non‐Pro Rata Allocations: The proposal would prevent an adviser from allocating fees or expenses on a non‐pro rata basis when multiple private funds have invested (or propose to invest) in the same portfolio investment.  This includes the allocation of both consummated and unconsummated expenses.
      • Analysis: This prohibition may be especially painful and difficult for managers to implement.  Many managers have sidecar vehicles that do not absorb expenses but where the flagship funds have agreed to bear such expenses.  Further, the release specifically discusses that yet‐to‐be‐created co‐investment vehicles should bear a portion of expenses, including broken deal expenses.  This may be difficult to implement in practice, and is sure to be an area of comment by industry.
    • Borrowing: The proposal would prohibit advisers from borrowing money from their funds.
      • Analysis: While this provision may seem sensible, it may unintentionally capture certain common industry practices.  For example, organizational costs are usually paid by private funds up to a cap.  Any organizational costs that exceed the cap are reimbursed to the fund by the manager via fee offsets.  Such an overage is effectively a loan from the fund to the manager and may be prohibited by the proposed rule.

Component 6: Preferential Treatment

• An investment adviser may no longer grant (1) preferential liquidity terms or (2) preferential access to information about a fund’s holdings to any substantially similar pool of capital if there is a reasonable expectation that such provisions could have a negative impact on other pools of assets.  This requirement does not apply to separately managed accounts.
  • Analysis: While this may affect some managers, most funds that have different liquidity sleeves will likely not be affected.  This is because the structure of those liquidity terms Page 4 don’t usually negatively affect the rest of the portfolio.  The rule smartly exempts separate accounts, which may now become more attractive given this prohibition.
• An investment adviser will need to do the following before providing any other preferential treatment to any investor in a private fund: (1) provide pre‐investment disclosure of preferential treatment; (2) provide annual written information about any preferences provided.
  • Analysis: This provision increases the amount of transparency, some of which is already provided to investors during the side letter negotiation process.  It is unclear whether the text of this rule would prevent preferred relationships from developing mid‐fund life (because of the need for pre‐commitment disclosure), but we do believe that this level of transparency will provide more negotiating leverage to LPs.

Component 7: Written Annual Review

• The proposed rule would require advisers to document their annual 206(4)‐7 review in writing whereas the previous rule simply required the performance of the annual review.  In the proposal, the staff discussed their desire to make more information available to staff and the Commission’s frustration over attorney‐client privilege claims of information that could be deemed to be part of the annual review as reasons for this proposed modification.
  • Analysis: Most advisers already document their annual review in writing and although this is a new requirement, it does not expand the scope of the annual review and does not add any new prescriptive elements.   The proposal does clarify, however, that the Commission does not believe that attorney‐client privilege applies to the annual review.