SEC finalises Private Fund Adviser Rules

The US Securities and Exchange Commission (the "SEC") has recently adopted new rules under the Investment Advisers Act of 1940 (the “Advisers Act”) (together, the “New Rules”), based on a set of proposals originally set out in February 2022 (the “Original Proposals”).

Although the New Rules are less onerous than the Original Proposals, they will still have a significant impact on the private funds industry, not only for registered investment advisers (“RIAs”) in the US but also other investment advisers outside of the US (including exempt reporting advisers (“ERAs”) i.e. firms which are exempt from full SEC registration under an exemption but who may still need to file a Form ADV with the SEC.

Under the New Rules, the SEC has omitted some of its Original Proposals and softened certain others from straightforward prohibitions to permitting certain actions only where there has been enhanced disclosure and, in some cases, investor consent. Nevertheless, the New Rules will increase the regulatory compliance burden (and related cost) associated with private funds and commentators have suggested this may signify a new, more interventionist approach from the SEC.

For the most part, advisers to private funds (including RIAs and ERAs) have been given some lead time to comply with the New Rules – typically 12 to 18 months, depending on AUM, after the date of publication in the Federal Register (often within a month of SEC adoption). Firms should prepare for the SEC to be focused on compliance with the New Rules, such as through examinations. Moreover, whilst, in principle, enhanced disclosure to investors has merits, it remains to be seen as to whether certain investors would find this useful.

In this briefing, we set out some of the key points from the New Rules.

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Restricted Activities Rules

Treatment of non-US advisers and funds
The rules in this section will not apply with respect to non-US private funds managed by non-US RIAs or ERAs, even if those non-US funds have US investors. It is notable that some aspects of these rules bear similarities to the EU and UK MiFID inducements rules.

GP Clawbacks

Under typical fund documents, amounts paid to the adviser may be clawed back by investors in certain circumstances. Under the New Rules, all advisers (including ERAs) are prohibited from reducing the amount of clawback by taxes (actual, potential or hypothetical) unless the adviser discloses in writing the pre-tax and post-tax amount of clawback to investors within 45 days following the end of the relevant fiscal quarter.

The prohibition in the Original Proposals has been softened, and now only applies where there has not been appropriate disclosure to investors.

Investigation expenses

Except where the paragraph below applies, all advisers (including ERAs) are prohibited from charging investigation fees and expenses (i.e., by a governmental or regulatory authority) to the fund unless the adviser requests each fund investor's consent and it receives written consent from a majority in interest of fund investors.

In all cases, however, advisers (including ERAs) may not charge investigation fees or expenses to the fund if the adviser is ultimately sanctioned for a violation under the Advisers Act (irrespective of any disclosures made and/or consents received).

The prohibition in the Original Proposals has been softened, and now only applies where there has not been appropriate disclosure to and consent from investors (except, as noted above, for fees or expenses related to an investigation that results in a sanction for a violation of the Advisers Act, where a prohibition applies).

Regulatory, examination or compliance expenses

All advisers (including ERAs) are prohibited from charging regulatory, examination or compliance expenses to the fund unless the adviser provides written notice of expenses (and amounts) to fund investors within 45 days following the end of the relevant fiscal quarter.

The prohibition in the Original Proposals has been softened, and now only applies where there has not been appropriate disclosure to investors.

Allocations of fees and expenses (on a non-pro rata basis)

All advisers (including ERAs) are prohibited from allocating fees and expenses relating to a portfolio investment between fund vehicles on a non-pro rata basis (e.g., if there is a fund and a co-invest vehicle, each must bear its pro-rated share) unless (a) the allocation approach is fair and equitable and (b) the adviser, in advance of allocation, distributes to investors written notice of the allocation and a description of how the allocation is fair and equitable.

The prohibition in the Original Proposals has been softened, and now only applies where the approach is not fair and equitable and/or there has not been appropriate disclosure to investors.

Credit from private fund clients

All advisers (including ERAs) are prohibited from borrowing or receiving an extension of credit from a private fund client unless the adviser discloses the material terms and obtains written consent from a majority in interest of fund investors.

The prohibition in the Original Proposals has been softened, and now only applies where there has not been appropriate disclosure to and/or consent from investors.

Original Proposals not adopted in the New Rules

Adviser indemnification

The Original Proposals would have prevented all advisers (including ERAs) from being indemnified by the fund for its standard negligence (rather than the higher threshold of gross negligence).

Fees for services not yet performed

The Original Proposals would have prevented all advisers (including ERAs) from charging fees to portfolio companies for services not yet performed (e.g., accelerated monitoring fees).

Preferential Treatment Rules

Treatment of non-US advisers and funds
The rules in this section will not apply with respect to non-US private funds managed by non-US RIAs or ERAs, even if those non-US funds have US investors. Again, it is notable from a European perspective that some aspects of these rules bear resemblance to the EU and UK AIFMD rules relating to preferential treatment of investors – although it remains to be seen in practice what the interplay will be with existing AIFMD practice and disclosure requirements.

Preferential treatment on redemptions

All advisers (including ERAs) are prohibited from providing preferential terms on redemptions to investors if the adviser reasonably expects such terms to have a material, negative effect on other investors in that fund unless (a) the adviser offers the same preferential redemption rights to all other investors or (b) the ability to redeem is required by an investor under the laws applicable to it.

The prohibition in the Original Proposals has been softened through a material, negative effect concept based on the reasonable expectations of the adviser, parity of terms amongst investors and a carve out for requirements under applicable laws. Note that there is an exception for “legacy funds” if an amendment to the governing documents would be needed (provided the governing documents were entered into prior to the compliance date).

Preferential treatment on information rights

All advisers (including ERAs) are prohibited from providing information to any investor in relation to the portfolio, or the fund’s exposure if the adviser reasonably expects that providing the information would have a material, negative effect on other investors in the fund unless the adviser offers such information to other fund investors at the same or substantially the same time.

The prohibition in the Original Proposals has been softened through a material, negative effect concept based on reasonableness and parity of information. Note that there is an exception for “legacy funds” if an amendment to the governing documents would be needed (provided the governing documents were entered into prior to the compliance date).

Disclosures to new investors

All advisers (including ERAs) are required to provide advanced written disclosure to prospective investors of any material economic terms (rather than all investment terms) that the adviser has provided to other investors.

The disclosure obligations in the Original Proposals have been limited by a materiality threshold in relation to economic terms.

Disclosures to current investors

All advisers (including ERAs) are required to provide an annual disclosure of all preferential treatment to all current investors (since the last annual notice). All advisers are also required to provide written notice of all preferential treatment to investors as soon as reasonably practicable following the end of the fund’s fundraising period.

Adviser-Led Secondaries Rules

Fairness opinion or valuation opinion

Advisers (only SEC-registered advisers and not ERAs) are required to obtain a fairness opinion or a valuation opinion from an independent provider on an adviser-led secondary transaction (which, contrary to the Original Proposals does not now include a tender offer transaction on the basis that an investor in this scenario would be given a true status quo option to retain its exposure to the relevant fund). The fairness or valuation opinion is required to be distributed to investors prior to the election form due date.

The requirement under the Original Proposals to obtain a fairness opinion has been softened to allow advisers the option of obtaining a less expensive valuation opinion instead. The SEC sees this rule as addressing an adviser’s conflict of interest when leading a secondary transaction.

Independence of fairness opinion provider

Advisers (only SEC-registered advisers and not ERAs) are required to provide a summary of any material business relationships that the adviser has had with the independent opinion provider within two years prior to issuance of the fairness or valuation opinion. The summary must be provided before the due date of the election form.

Reporting, Audits and Compliance Rules

Quarterly statements and reports

Advisers (only SEC-registered advisers and not ERAs) are required to provide investors with quarterly statements (which includes certain information on fees, expenses, and fund performance) for Q1, Q2 and Q3 within 45 days of quarter-end (75 days for fund of funds), and quarterly statements for Q4 within 90 days of the end of the fiscal year (120 days for fund of funds).

Additional time has been provided to allow advisers to prepare fourth quarter reports, and for fund of funds to prepare quarterly reporting, more generally. The SEC confirmed that the quarterly statement rule itself does not restrict/limit the kinds of additional reporting which investors may negotiate.

Annual audits

Advisers (only SEC-registered advisers and not ERAs) are required to obtain an annual financial statement audit of their private funds, which is a requirement harmonised with the audit provisions established in the Advisers Act Custody Rule.

Compliance review

Advisers (only SEC-registered advisers and not ERAs) are required to document the annual review of their compliance policies and procedures in writing.

Implementation

Grandfathering

Rather than grandfathering provisions, legacy status is given in relation to aspects of the Preferential Treatment rules (preferential redemption and portfolio information) and the Restricted Activities rules (borrowing and investigation expenses).

Legacy status applies to fund governing documents (including side letters) that:

a) were entered into prior to the compliance date (if the rule would require amendments to maintain compliance with the rules); and

b) only if the fund has already commenced operations as at the compliance date.

            
        Compliance dates
    
Compliance review rules (as noted above, these rules do not apply to ERAs) will be required 60 days after publication of the new requirements in the Federal Register (publication is often done shortly after SEC adoption, commonly between a week and a month).

Audit and quarterly statement rules will be required 18 months after publication of the new requirements in the Federal Register.

Adviser-led secondary rules, preferential treatment rules and restricted activities rules will be required between 12 and 18 months after publication of the new requirements in the Federal Register (depending on AUM).