SEC Adopts New Private Fund Adviser Rules

The SEC adopted its much anticipated private fund reforms on August 23, 2023. These reforms include several quarterly reporting requirements with respect to performance and fees and expenses, increased transparency regarding side letters and other “preferential treatment” for fund investors, prohibitions on certain liquidity rights and information sharing with fund investors, and limitations on the ability of fund managers to obtain reimbursement from private funds for costs associated with government investigations.

Nevertheless, taken as a whole, the reforms are less transformational than the proposal from February 2022. Rather than the proposed “prohibited activities rule,” the SEC adopted a “restricted activities rule.” This rule addresses many of the practices covered by the initial SEC proposal, such as fee and expense allocation practices and treatment of adviser clawbacks. However, for the most part the restricted activities rule creates disclosure obligations for advisers along with, in some cases, consent requirements, in place of per se prohibitions. One item from the proposed rule that is noticeably absent from the final rule: the provision that would have dictated by rule an adviser’s standard of care under private fund agreements. The finalized reforms, unlike the proposed rules, also include “legacy” provisions that exempt existing fund governing agreements from certain aspects of the preferential treatment and restricted activities rules. The following is a summary of the requirements imposed by the new rules.

Compliance Timeline for New Rules

The SEC set varying compliance dates for the new rules depending on the rule and size of the adviser:

• Larger private fund advisers (defined as advisers with $1.5 billion or more in private fund assets under management) have a compliance date of 18 months after publication in the federal register (expected in a few weeks) for the quarterly statement and audit rules, but 12 months after publication in the federal register for the adviser-led secondaries, preferential treatment and restricted activities rules.
• Smaller private fund advisers (defined as advisers with less than $1.5 billion in private fund assets under management) have a compliance date of 18 months after publication in the federal register for all new rules.
• The SEC adopted a new requirement that all SEC-registered advisers document their Rule 206(4)-7 annual review of compliance policies and procedures. The compliance date for this requirement is 60 days after publication in the federal register (i.e., for the next annual review occurring after the compliance date).
• For purposes of determining size as a “smaller” or “larger” private fund adviser, the SEC stated that advisers should calculate private fund assets under management (in the same manner as for Form PF) as of the last day of the adviser’s most recently completed fiscal year.

As part of the reforms package, the SEC also adopted changes to recordkeeping requirements, which are addressed further below. These private fund reforms will require advisers to adopt substantial amendments to their existing compliance policies and procedures to satisfy their Rule 206(4)-7 obligations.

Scoping for New Rules

• Impact of Fund Type. As further detailed below, the new rule requirements apply to advisers (though in some cases only registered investment advisers) to “private funds,” meaning those funds that would be an investment company, as defined in section 3 of the Investment Company Act, but for section 3(c)(1) or 3(c)(7) of the Investment Company Act. The new rules (the quarterly statement, audit, adviser-led secondaries, preferential treatment and restricted activities rules) will not apply to investment advisers with respect to the securitized asset funds they advise. (“Securitized asset fund” means any private fund whose primary purpose is to issue asset-backed securities and whose investors are primarily debt holders (e.g., CLOs).) More detail on the carve-out is included at the end of this Alert.
• Impact of Adviser Registration Status. The restricted activities and preferential treatment rules apply to all private fund advisers, including U.S. private fund managers relying on the private fund adviser exemption and fund managers relying on the venture capital fund adviser exemption. The quarterly statement, audit and adviser-led secondaries rules apply to registered private fund advisers only. The amended rule requiring documentation of annual reviews only applies to SEC-registered advisers (including advisers that do not manage private funds).
• Non-U.S. Funds. In the adopting release, the SEC restated its prior position that the SEC does not apply most of the substantive provisions of the Advisers Act with respect to the non-U.S. clients (including private funds) of an SEC-registered offshore adviser. The SEC also clarified that with respect to non-U.S. unregistered advisers (e.g., non-U.S. ERAs), the restricted activities and preferential treatment rules (which, as noted, also apply to unregistered advisers) do not apply to non-U.S. unregistered advisers with respect to their non-U.S. funds (regardless of whether the funds have U.S. investors).

Legacy Status

The legacy, or grandfathering, provisions apply to (i) the portion of the preferential treatment rule that prohibits certain redemption and information rights, and (ii) the portion of the restricted activities rule applicable to adviser borrowing from a fund and an adviser charging investigation fees and expenses to a fund. This Alert indicates where “legacy status” applies in the discussion of the rules, and to give some initial context:

• Each legacy provision operates the same way. A grandfathered portion of the rules does not apply to private fund governing agreements where (i) the fund has commenced operations as of the compliance date, (ii) the governing agreements were entered into prior to the compliance date, and (iii) the portion of the rules (if applied and not grandfathered) would require the parties to amend such governing agreements.
• The SEC noted in the adopting release that, for purposes of the legacy provisions, private fund governing agreements include the fund’s operating or organizational agreements (e.g., LPAs), subscription agreements and side letters, and a fund has commenced operations if it has engaged in bona fide investment, fundraising or operational activity.

Preferential Treatment Rule (Rule 211(h)(2)-3) (applicable to all private fund advisers)

• Prohibited Preferential Treatment. The rule prohibits all private fund advisers, including those that are not SEC-registered, from, either directly or indirectly, (i) providing preferential redemption terms to an investor in a private fund or in a similar pool of assets that the adviser reasonably expects to have a material, negative effect on other investors in that private fund or similar pool of assets, or (ii) providing 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 the exceptions below.
  • An adviser is not prohibited from offering preferential redemption rights (i) to an investor that is required to redeem due to applicable laws, rules, regulations or orders of any relevant foreign or U.S. government, state or political subdivision to which the investor, private fund or any similar pool of assets is subject, or (ii) if the adviser has offered the same redemption ability to all existing investors and will continue to offer the same redemption ability to all future investors in the private fund or similar pool of assets.
    • The exception in (i) above does not apply to redemption rights given due to an investor’s internal policies or compliance requirements.
    • The exception in (ii) above does not require that all investors have identical redemption rights, only that they be offered the same rights. For instance, an adviser could offer all investors an option between (a) a higher fee structure/more frequent redemption rights and (b) a lower fee structure/less frequent redemption rights, without running afoul of the rule. However, to rely on this provision, advisers must offer the same options to all existing investors and to continue to offer such redemption ability to all future investors. Further, the adopting release sets forth the SEC’s view that to qualify for this exception, the alternatives must be offered without qualification (such as a minimum commitment size, or an alternative only available to affiliates of the adviser).
  • An adviser is not prohibited from offering preferential information rights if the adviser offers such information to all other existing investors in the private fund and any similar pool of assets at the same time or substantially the same time.
  • The SEC acknowledged that it is easier to trigger the “material, negative effect” in an open-end fund context where certain investors receive preferential information and have an ability to redeem their interests. While the SEC noted that it would generally not view preferential information rights provided to one or more investors in a closed-end private fund as having a “material, negative effect” on other investors, they declined to provide a blanket exemption for all closed-end funds because some closed-end funds offer redemption rights in certain extraordinary circumstances.
  • Similar Pool of Assets. The rule applies to the granting of preferential terms to certain investors in a private fund or in a “similar pool of assets.” The SEC stated it changed, from the proposal, the applicable term from “substantially similar” to “similar” to better reflect its intended broad scope and noted that the term could, for instance, capture an adviser’s funds with a different sector or geographical focus. However, the actual definition has not changed from the proposed rule: a “similar pool of assets” is another pooled investment vehicle (other than a registered investment company) with “substantially similar investment policies, objectives, or strategies” as the private fund. Whether a pool of assets managed by an adviser is a “similar pool of assets” to a private fund is a facts and circumstances test, but the adopting release clarifies that the term includes a variety of pooled vehicles, regardless of whether they are private funds. The SEC also noted that “similar pool of assets” is worded to be broader than “related portfolio” under the SEC’s marketing rule (Rule 206(4)-1).
  • “Legacy status” does apply to this portion of the rule as noted above.
• Preferential Rights Permitted with Disclosure. The rule allows advisers to grant to investors other preferential rights so long as such preferential treatment is disclosed in a written notice to prospective and current investors. While the SEC did not mandate a particular form for disclosing these preferential terms, the adopting release clarifies that an adviser must describe specifically the preferential treatment to convey its relevance. In particular, the SEC noted that the mere disclosure of the fact that other investors are paying lower fees is insufficient. Instead, an adviser must describe the lower fee terms (including applicable rate, if relevant) to provide the information required by the rule. Alternatively, the adviser could provide copies of the relevant side letters or terms (while redacting any investor-identifying information).
  • Written Notice to Prospective Investors. Written notice must be distributed to each prospective investor prior to the investor’s investment in the private fund relating to any material economic terms (as opposed to requiring advance disclosure of all preferential rights) that are provided to other investors in the same private fund. This would include terms relating to the cost of investing, liquidity rights, fee breaks and co-investment rights.
  • Written Notice to Current Investors. Written notice must also be distributed to current investors of all preferential treatment (including those unrelated to material economic terms) provided to other investors in the same private fund (i) for an illiquid fund, as soon as reasonably practicable following the end of the fund’s fundraising period; and (ii) for a liquid fund, as soon as reasonably practicable following the investor’s investment in the private fund. Additionally, on at least an annual basis, an adviser must distribute to current investors written notice of any preferential treatment provided to investors in the same private fund since the last written notice provided (if any). Note that the granting of preferential redemption or information rights pursuant to one of the exceptions noted above is also subject to these disclosure requirements.
  • “Legacy status” is not available for this portion of the preferential treatment rule.

Restricted Activities Rule (Rule 211(h)(2)-1) (applicable to all private fund advisers)

In a modification from the proposal, this final rule restricts all private fund advisers, including those that are not SEC-registered, from engaging in certain activities and practices, regardless of whether a fund’s governing documents permit such activities, unless they satisfy the specific disclosure and, in some cases, consent requirements of the rule. These practices include (i) certain non-pro rata fee and expense allocations; (ii) reduction of adviser clawbacks for taxes; (iii) certain regulatory, compliance, examination and investigation fees and expenses; and (iv) borrowing or receiving an extension of credit from a client.

• Certain Non-Pro Rata Fee and Expense Allocations. The rule restricts an adviser from directly or indirectly charging or allocating fees and expenses related to a portfolio investment or potential portfolio investment (which would include dead deal costs) on a non-pro rata basis when multiple clients advised by the adviser or its related persons have invested (or propose to invest) in the same portfolio investment unless (i) the non-pro rata charge or allocation is fair and equitable under the circumstances and (ii) prior to charging or allocating such fees or expenses to a private fund client, the investment adviser distributes to each private fund investor a written notice of the non-pro rata charge or allocation and a description of how it is fair and equitable under the circumstances.
  • The adopting release noted that what is “fair and equitable” depends on the facts and circumstances and could vary based on the particular expense. The SEC provided a few examples of factors in the adopting release that an adviser could consider in determining whether a non-pro rata allocation was “fair and equitable,” including expenses related to a bespoke structuring arrangement for one private fund client and whether one private fund client may receive a greater benefit from the expense relative to other private fund clients (such as with respect to insurance policies).
  • “Legacy status” is not available for this portion of the restricted activities rule.
• Reduction of Adviser Clawbacks for Taxes. The rule restricts an adviser from reducing the amount of any adviser clawback by actual, potential or hypothetical taxes applicable to the adviser, its related persons or their respective owners or interest holders, unless the adviser distributes a written notice to the investors that sets forth the aggregate dollar amounts of the adviser clawback both before and after any such reduction of the clawback for actual, potential or hypothetical taxes within 45 days after the end of the fiscal quarter in which the adviser clawback occurs.
  • In response to commenters, including Ropes & Gray, the SEC in the adopting release stated that an outright prohibition on the practice was not necessary and shifted to a regime permitting the practice with specific disclosure after the occurrence of the event.
  • Adviser clawback is defined under the rule as any obligation of the adviser, its related persons or their respective owners or interest holders to restore or otherwise return performance-based compensation to the private fund pursuant to the private fund’s governing agreements.
  • “Legacy status” is not available for this portion of the restricted activities rule.
• Regulatory, Compliance and Examination Fees and Expenses. The rule restricts an adviser from charging or allocating to a private fund any regulatory or compliance fees or expenses, or fees or expenses associated with an examination, of the adviser or its related persons, unless the adviser distributes a written notice of any such fees or expenses, and the dollar amount thereof, to investors in writing on at least a quarterly basis and within 45 days after the end of the fiscal quarter in which the charge occurs.
  • Charging funds for regulatory, compliance or other similar fees and expenses directly related to the activities of the fund does not trigger the notice requirements of the rule (e.g., costs associated with a regulatory filing of a fund, such as Form D).
  • “Legacy status” is not available for this portion of the restricted activities rule.
• Investigation Fees and Expenses. The rule restricts an adviser from charging or allocating to a private fund fees or expenses associated with an investigation of the adviser or its related persons by any governmental or regulatory authority, unless the adviser seeks consent from all the private fund’s investors and obtains written consent from at least a majority in interest of the fund’s investors that are not related persons of the adviser for such charge or allocation.
  • However, advisers cannot (regardless of LP consent) charge or allocate to the private fund fees or expenses related to an investigation that results in a court or governmental authority imposing a sanction for a violation of the Advisers Act or the rules promulgated thereunder.
  • The consent requirement applicable to allocating investigation fees and expenses to a fund includes investigations by any governmental or regulatory authority, not just SEC investigations. In addition, while the language in the rule relating to consents is limited to “fees or expenses associated with an investigation,” the adopting release seems to suggest these fees and expenses include fines and penalties imposed by the governmental or regulatory authority.
  • “Legacy status” does apply to this portion of the rule as noted above, except that such legacy provision does not permit an investment adviser to charge or allocate to a private fund fees or expenses related to an investigation that results or has resulted in a court or governmental authority imposing a sanction for a violation of the Advisers Act or its rules.
• Borrowing or Receiving an Extension of Credit from a Client. The rule restricts an adviser from directly or indirectly borrowing money, securities or other fund assets, or receiving a loan or an extension of credit, from a private fund client, such as using fund assets as collateral to obtain a loan from a party other than the fund (i.e., borrowing against fund assets), accepting a loan offered by a private fund client and taking advantage of a continuous line of credit extended by a private fund client unless the adviser (i) distributes to each investor a written description of the material terms of, and requests each investor to consent to, such borrowing, loan or extension of credit; and (ii) obtains written consent from at least a majority in interest of the private fund’s investors that are not related persons of the adviser. Material terms to be disclosed in connection with the consent request include, for example, the amount of money to be borrowed, the interest rate and the repayment schedule.
  • The rule does not prevent or otherwise restrict (i) an adviser from borrowing from a third party on the fund’s behalf or from lending to the fund, (ii) a fund from facilitating tax advances to the adviser or its affiliates to meet certain tax obligations as they become due (but would restrict such advance if it contemplated amounts to be repaid to the fund as opposed to amounts that only reduce an adviser’s future income) and (iii) management fee offsets.
  • “Legacy status” does apply to this portion of the rule as noted above.
• Significant Changes from the Proposed Rules.
  • Limiting or Eliminating Liability – As noted above, the SEC declined to adopt one of the more controversial provisions of the proposed rule: the proposal that would have prohibited an adviser to a private fund, directly or indirectly, from seeking reimbursement, indemnification, exculpation or limitation of its liability by the private fund or its investors for a breach of fiduciary duty, willful misfeasance, bad faith, negligence or recklessness in providing services to the private fund (the “waiver or indemnification prohibition”).
    • The adopting release includes in-depth discussion regarding this dropped prohibition. The SEC stated that it was not adopting the proposal because “much of the activity that it would have prohibited is already prohibited” under federal fiduciary duty and antifraud provisions.
    • The adopting release includes a discussion, which the SEC described as reaffirming and clarifying its views, on how an adviser’s fiduciary duty applies to its private fund clients and how the antifraud provisions apply to the adviser’s dealings with clients and fund investors. The SEC stated: (i) a waiver of an adviser’s compliance with its federal antifraud liability for breach of its fiduciary duty to a private fund or otherwise, or any other provision of the Advisers Act or its rules, is invalid under the Advisers Act; (ii) an adviser may not seek reimbursement, indemnification or exculpation for breaching its federal fiduciary duty because such reimbursement, indemnification or exculpation would operate effectively as a waiver, which would be invalid under the Advisers Act; and (iii) breach of the federal fiduciary duty may involve conduct that is intentional, reckless or negligent.
  • Accelerated Payments – The SEC also did not adopt the proposed prohibition on charging a portfolio investment for monitoring, servicing, consulting or other fees in respect of any services the investment adviser does not, or does not reasonably expect to, provide to the portfolio investment.
    • The SEC stated that it is unnecessary for a final rule to prohibit an adviser from charging fees without providing a corresponding service to its private fund client because such activity already is inconsistent with the adviser’s fiduciary duty. The SEC further stated that an adviser is not permitted to charge for services that it does not reasonably expect to provide, and, to the extent that the adviser ultimately does not provide the services, the adviser would need to refund any prepaid amounts attributable to unperformed services.

Quarterly Statement Rule (Rule 211(h)(1)-2) (applicable to registered private fund advisers only)

• General Rule Requirements. The quarterly statement rule requires a registered investment adviser to prepare a quarterly statement that includes certain information regarding fees, expenses and performance (further described below) for any private fund that it advises and distribute the quarterly statement to the fund’s investors within 45 days after the end of each of the first three fiscal quarters of each fiscal year and 90 days after the end of each fiscal year (if the private fund is a fund of funds, then a quarterly statement must be distributed within 75 days after each of the first three fiscal quarters of each fiscal year and 120 days after the end of each fiscal year), unless a quarterly statement that complies with the quarterly statement rule is prepared and distributed by another person (e.g., in the case of a sub-advised fund).
  • Under the definition of “distribute,” the statement must be sent to all investors in the private fund. If the investor is a pooled investment vehicle controlled by the adviser or its related persons (defined consistently with Form ADV), investors in those pools must receive the statements.
  • The SEC noted that if a quarterly statement is distributed electronically through a data room, then this distribution should be done in accordance with the SEC’s guidance on electronic delivery. Accordingly, advisers should notify investors when the quarterly statement is uploaded to the data room within the applicable time periods for preparation and delivery of the statement noted above and ensure that all investors have access to the quarterly statement therein.
  • The adopting release clarifies that the quarterly statement required by the rule is just a baseline-level reporting requirement and does not restrict or limit the kinds of additional reporting for which an investor may negotiate. However, investors may not waive the quarterly statement requirement.
  • The quarterly statement rule requires advisers to consolidate reporting for similar pools of assets (defined as referenced above) to the extent doing so would provide more meaningful information to the fund’s investors and would not be misleading (e.g., in the case of parallel and master-feeder structures).
  • The quarterly statement rule requires the adviser to a newly formed private fund to prepare and distribute a quarterly statement beginning after the fund’s second full fiscal quarter of generating operating results (and such initial quarterly statement must include the first two full fiscal quarters of operating results).
• General Format and Content Requirements; Disclosure. The quarterly statement rule includes general format and content requirements meant to improve legibility and to make comparing funds easier (but it purposefully does not go so far as to mandate a specific reporting structure).
  • The quarterly statement must use clear, concise, plain English and be presented in a format that facilitates review from one quarterly statement to the next.
  • The quarterly statement rule requires fees and expenses to be listed as separate line items by total dollar amount per specific category (e.g., insurance premiums, administrator expenses or auditor fees).
  • The quarterly statement rule does not permit the exclusion of de minimis expenses, the general grouping of smaller expenses into broad categories or the labeling of expenses as miscellaneous.
  • The quarterly statement rule also requires an adviser to present the dollar amount of compensation, fund expenses and portfolio investment compensation before and after any reduction due to offset, rebate or waiver for the reporting period.
  • An adviser remains free to include other performance metrics in the statement as long as the quarterly statement presents the performance metrics prescribed by the quarterly statement rule and complies with the other requirements in the rule.
  • Each statement must include prominent disclosure regarding the manner in which expenses, payments, allocations, rebates, waivers and offsets are calculated. This disclosure will generally require advisers to describe, among other things, the structure of, and the method used to determine, any performance-based compensation set forth in the quarterly statement (such as the distribution waterfall, if applicable) and the criteria on which each type of compensation is based (e.g., whether such compensation is fixed, based on performance over a certain period, or based on the value of the fund’s assets).
  • The quarterly statement must also include cross references to the relevant sections of the private fund’s organizational and offering documents that set forth the applicable calculation methodology with respect to expenses, payments, allocations, rebates, waivers and offsets.
• Fund-Level Disclosure of Adviser Compensation and Fund Fees and Expenses. Under the quarterly statement rule, advisers are required to provide the following information in table format: (i) detailed accounting of all compensation, fees and other amounts allocated or paid to the adviser or any of its related persons (defined consistently with Form ADV) by the fund during the reporting period; (ii) detailed accounting of all fees and expenses allocated to or paid by the fund during the reporting period other than those listed in (i); and (iii) the amount of any offsets or rebates carried forward during the reporting period to subsequent quarterly periods to reduce future payments or allocations to the adviser or its related persons.
  • Adviser compensation includes, but is not limited to, management, advisory, sub-advisory or similar fees or payments and performance-based compensation (including performance-based compensation that is in-kind). It includes any compensation, fees or other amounts allocated or paid to the adviser or its related persons for any non-advisory services they provide to the private fund such as consulting, legal or back-office services.
  • Fund fees and expenses include, but are not limited to, organizational, accounting, legal, administration, audit, tax, due diligence and travel expenses. They also include start-up and organizational fees of the fund if they were paid during the reporting period.
• Portfolio Investment-Level Disclosure on Compensation and Ownership. Under the quarterly statement rule, advisers are required to provide the following information in table format: a detailed accounting of all portfolio investment compensation allocated or paid to the adviser or its related persons by each covered portfolio investment during the reporting period, with separate line items for each category.
  • “Portfolio investment” is broadly defined to include any entity or issuer in which a private fund has invested directly or indirectly. The definition may therefore capture more than one entity or issuer with respect to any single investment made by a private fund (e.g., if a private fund invests in a holding company that owns two subsidiaries, the definition captures all three).
  • The quarterly statement rule requires advisers to disclose information regarding only “covered portfolio investments,” which are portfolio investments that allocated or paid the investment adviser or its related persons portfolio investment compensation during the reporting period.
  • “Portfolio investment compensation” means any compensation, fees and other amounts allocated or paid to the adviser or any of its related persons by the portfolio investment attributable to the private fund’s interest in such portfolio investment. Therefore, the amount should not reflect the portion attributable to any other person’s (e.g., a co-investor’s) interest in the covered portfolio investment.
  • Portfolio investment compensation includes, but is not limited to, origination, management, consulting, monitoring, servicing, transaction, administrative, advisory, closing, disposition, directors, trustees, or similar fees or payments. The adopting release clarifies that portfolio investment compensation does not include distributions representing profit or return of capital in respect of a fund’s ownership or other interest in a portfolio investment (e.g., dividends).
  • The SEC proposed but ultimately did not adopt a requirement that advisers also disclose the private fund’s ownership percentage of each covered portfolio investment.
• Performance Disclosure. In addition, the quarterly statement rule requires an adviser to include standardized fund performance information in each quarterly statement provided to fund investors and to include prominent disclosure of the criteria used and assumptions made in calculating such performance. The performance disclosure requirements of the quarterly statement rule require an adviser first to determine whether its private fund client is an “illiquid” or “liquid” fund no later than the time the adviser sends an initial quarterly statement, because determining which requirements are applicable would be dependent on that characterization.
  • An illiquid fund is defined as one that (i) is not required to redeem interests upon an investor’s request and (ii) has limited opportunities, if any, for investors to withdraw before termination of the fund. A liquid fund includes any other fund. The definition of illiquid fund represents a significant simplification relative to the proposing release, which included six factors that had to be met for a fund to be classified as an illiquid fund.
  • For illiquid funds, the quarterly statement rule requires an adviser to show performance since inception through the end of the quarter covered by the quarterly statement based on the fund’s gross and net IRR and MOIC (both of which have specific definitions to limit any deviations in calculating the standard performance prescribed by the rule), as well as gross IRR and MOIC for the realized and unrealized portions of the illiquid fund’s portfolio. The quarterly statement for an illiquid fund must also present a statement of contributions and distributions.
    • The quarterly statement rule defines IRR as the discount rate that causes the net present value of all cash flows throughout the life of the private fund to be equal to zero. Cash flows will be represented by capital contributions (i.e., cash inflows) and fund distributions (i.e., cash outflows), and the unrealized value of the fund will be represented by a fund distribution (i.e., a cash outflow).
    • MOIC is defined as (i) the sum of (A) the unrealized value of the illiquid fund; and (B) the value of all distributions made by the illiquid fund; (ii) divided by the total capital contributed to the illiquid fund by its investors.
    • Under the rule, net IRR is defined as the internal rate of return that is calculated net of all fees, expenses and performance-based compensation borne by the private fund, and net MOIC is defined as a multiple of invested capital that is calculated net of all fees, expenses and performance-based compensation borne by the private fund.
    • The quarterly statement rule requires advisers to calculate performance measures for each illiquid fund with and without the impact of fund-level subscription facilities. For performance measures without the impact of fund-level subscription facilities, this means advisers must calculate performance as if the private fund called investor capital, rather than drawing down on fund-level subscription facilities (for which advisers would have to exclude associated fees and expenses).
    • An adviser must disclose the assumed fee rates including whether the adviser is using fee rates set forth in the fund documents, whether it is using a blended rate or weighted average that would factor in any discounts, or whether it is using a different method for calculating net performance.
  • For liquid funds, the quarterly statement rule requires an adviser to show (i) annual net total return (which is not defined in the rule) for each fiscal year over the past 10 fiscal years or since inception (whichever time period is shorter); (ii) average annual net total returns over the one-, five- and 10- fiscal-year periods if applicable; and (iii) cumulative net total return for the current fiscal year as of the end of the most recent fiscal quarter covered by the quarterly statement.
  • The quarterly statement rule requires an adviser to display the different categories of required performance information with equal prominence. If the adviser made any assumptions in performing that calculation, such as whether dividends were reinvested, the adviser must disclose those assumptions in the quarterly statement.
  • An adviser must provide all required information in the quarterly report itself and may not provide any information in a separate document, website hyperlink or QR code, or other separate disclosure.
  • The rule defines “reporting period” for a newly formed private fund as the period covering the fund’s first two full fiscal quarters of operating results.
  • While in the proposing release, the SEC asked commenters whether certain common private fund fee and expense arrangements should be prohibited (i.e., the “2 and 20 model”), such prohibitions were not ultimately adopted.

Mandatory Private Fund Adviser Audits Rule (Rule 206(4)-10) (applicable to registered private fund advisers only)

The mandatory private fund adviser audits rule requires a registered investment adviser providing investment advice, directly or indirectly, to a private fund, to cause that fund to undergo a financial statement audit that meets the requirements set forth in paragraphs (b)(4)(i) through (b)(4)(iii) of Advisers Act Rule 206(4)-2 (the “Custody Rule”) and to cause audited financial statements to be delivered in accordance with paragraph (c) of the Custody Rule. As a result, each of the following is required under the final rule:

• The audit must be performed by an independent public accountant that meets the standards of independence in rule 2-01(b) and (c) of Regulation S-X that is registered with and subject to regular inspection as of the commencement of the professional engagement period, and as of each calendar year-end, by the PCAOB in accordance with its rules;
• The audit must meet the definition of audit in rule 1-02(d) of Regulation S-X, meaning that financial statement audits performed for purposes of the final rule will generally need to be performed in accordance with U.S. GAAS;
• Audited financial statements must be prepared in accordance with U.S. GAAP, or some other comprehensive body of accounting standards similar to U.S. GAAP if the differences are reconciled to U.S. GAAP; and
• Annually within 120 days of the private fund’s fiscal year-end and promptly upon liquidation, the private fund’s audited financial statements must be delivered to investors in the private fund.
  • The SEC noted that it believes that a 180-day time period is appropriate in the context of a fund of funds and that a 260-day time period is appropriate in the context of a fund of funds of funds (similar to guidance under the Custody Rule).
  • In circumstances where an investor is itself a limited partnership, limited liability company or another type of pooled vehicle that is a related person of the adviser, it is necessary to look through that pool (and any pools in a control relationship with the adviser or its related persons, such as in a master-feeder fund structure), to send to investors in those pools.
  • Outside of a control relationship, such as if the private fund investor is an unaffiliated fund of funds, it is not necessary to look through the structure to make meaningful delivery. It will be sufficient to distribute the audited financial statements to the adviser to, or other designated party of, the unaffiliated fund of funds.
• For a fund that the adviser does not control and that is neither controlled by nor under common control with the adviser (e.g., a sub-adviser to a private fund), such adviser needs to take all reasonable steps to cause the fund to undergo an audit that meets these elements described above, if the private fund does not otherwise undergo such an audit.
  • The SEC noted that what would constitute “all reasonable steps” depends on the facts and circumstances and that, for example, in the case of a sub-adviser, including (or seeking to include) the requirement for a fund to undergo an audit in the sub-advisory agreement would satisfy this requirement.
• The SEC also restated its prior guidance regarding the rule’s applicability to special purpose vehicles (“SPVs”). The adopting release stated that if the adviser treats an SPV as a separate client, the mandatory private fund audits rule will require an audit of the SPV. If, however, the adviser treats the SPV’s assets as the pooled investment vehicle’s assets that it is advising indirectly, the SPV’s assets will be required to be considered within the scope of the pooled investment vehicle’s financial statement audit and a separate audit of the SPV is not required.

Adviser-Led Secondaries Rule (Rule 211(h)(2)-2) (applicable to registered private fund advisers only)

This rule requires a registered adviser conducting an adviser-led secondary transaction with respect to any private fund that it advises to distribute to investors in the private fund, prior to the due date of the election form for the transaction, (i) a fairness opinion or (in a change from the proposal) a valuation opinion from an independent opinion provider and (ii) a summary of any material business relationships the adviser or any of its related persons has, or has had within the two-year period immediately prior to the issuance date of the opinion, with the independent opinion provider.

• The SEC changed the timing of providing the opinion and summary of material business relationships from prior to the closing of the transaction to prior to the due date of the election form for the transaction.
• For purposes of the rule, audit, consulting, capital raising, investment banking and other similar services would typically meet the “material business relationship” standard that triggers disclosure.
• Defined Terms Specific to the Rule.
  • The rule defines adviser-led secondaries as transactions initiated by the investment adviser or any of its related persons that offer the private fund’s investors the choice between (i) selling all or a portion of their interests in the private fund and (ii) converting or exchanging all or a portion of their interests in the private fund for interests in another vehicle advised by the adviser or any of its related persons.
    • Examples of such transactions may include single asset transactions (such as the fund selling a single asset to a new vehicle managed by the adviser), strip sale transactions (such as the fund selling a portion of multiple assets to a new vehicle managed by the adviser) and full fund restructurings (such as the fund selling all its assets to a new vehicle managed by the adviser).
    • The SEC clarified that the rule would not generally apply to cross-trades (including rebalancing between parallel funds and season and sell transactions between parallel funds).
    • In addition, unlike the proposal, the rule would not apply to tender offers or other transactions as long as the investor is not faced with the decision between (i) selling all or a portion of its interest and (ii) converting or exchanging all or a portion of its interest. For example, the rule would not apply to transactions where the choice is between (a) selling all or a portion of an investor’s interest in the private fund and (b) maintaining the status quo (i.e., simply continuing to hold the investor’s existing fund interest).
  • “Fairness opinion” means a written opinion stating that the price being offered to the private fund for any assets being sold as part of an adviser-led secondary transaction is fair.
  • “Valuation opinion” means a written opinion stating the value (as a single amount or a range) of any assets being sold.
  • “Independent opinion provider” means a person that (i) provides fairness opinions or valuation opinions in the ordinary course of its business and (ii) is not a related person of the adviser.
  • “Election form” means a written solicitation distributed by, or on behalf of, the adviser or any related person requesting private fund investors to make a binding election to participate in an adviser-led secondary transaction.

Recordkeeping

The SEC instituted additional recordkeeping requirements for all new rules. The following documents must be made and retained, for each rule:

• Quarterly Statement Rule: Copies of any distributed quarterly statement; a record of each addressee and the dates the statement was sent; records evidencing the calculation method for all expenses, payments, allocations, rebates, offsets, waivers and performance listed on any quarterly statement delivered; and books and records substantiating the adviser’s determination that a private fund client is a liquid fund or an illiquid fund.
• Mandatory Private Fund Adviser Audits Rule: A copy of any audited financial statements; a record of each addressee and the corresponding date(s) sent; and a record documenting steps taken by the adviser to cause a private fund client with which it is not in a control relationship to undergo a financial statement audit.
• Adviser Led Secondaries Rule: A copy of the fairness opinion or valuation opinion and material business relationship summary distributed to investors; and a record of each addressee and the date(s) the opinion and summary were sent.
• Preferential Treatment Rule: Copies of all written notices sent to current and prospective investors in a private fund; and a record of each addressee and the corresponding dates sent.
• Restricted Activities Rule: A copy of any notification, consent or other document distributed to or received from private fund investors; and a record of each addressee and the corresponding date(s) sent for each such document distributed by the adviser.

Exempted Funds (Securitized Asset Funds)

As noted above, the new rules do not apply to investment advisers with respect to securitized asset funds (“SAFs”). The SEC explained in the adopting release that certain distinguishing structural and operational features of SAFs deter SAF advisers from engaging in the type of conduct that the final rules seek to address, and the advisory relationship between advisers and SAFs presents different regulatory issues than other advisory relationships under consideration for purposes of these rules.

Data Room Delivery

As referenced above, the SEC noted that if a quarterly statement is distributed electronically through a data room, then this distribution should be done in accordance with the SEC’s guidance on electronic delivery. The SEC also suggested in the adopting release that the data room posting method for quarterly statements would also be permissible for other aspects of the new rules, including (i) distribution of any fairness or valuation opinion and description of material business relationships, under the adviser-led secondaries rule, and (ii) distribution of certain written notices, under the restricted activities and preferential treatment rules.

Documentation of Annual Compliance Reviews

The SEC adopted, as it had proposed, the requirement that all SEC-registered advisers (whether they advise private funds or not) document the annual review of their compliance policies and procedures. This amended rule’s compliance date is shorter than the new rules – the compliance date is within 60 days after publication in the federal register. The rule does not prescribe a specific format for the written documentation, and the SEC noted that advisers have the flexibility to record the results of the annual review in a manner that best fits their business and to use the review procedures that they have found most effective. The SEC provided guidance for timing of reviews considering the compliance date. Whenever an adviser commences its annual review within the next 12 months after the compliance date, the review must be documented in writing. The SEC also stated, in the adopting release, that to the extent an adviser has a review year that is partially complete by the compliance date and the adviser has already reviewed the adequacy of its policies and procedures in accordance with the compliance rule (Rule 206(4)-7) for such period prior to the compliance date, the new documentation requirement will not apply retroactively to such period.