Though they’ve already been challenged in court, a slate of new rules from the SEC seek to regulate multiple aspects of financial advisers’ relationships with private funds and their investors. A trio of experts from Eversheds Sutherland break down the agency’s reforms.
Issa J. Hanna, Michael B. Koffler and Ethan D. Corey co-authored this report.
In August, a divided SEC adopted far-reaching new rules and amendments under the Investment Advisers Act of 1940. While the final rules are not as burdensome as the versions initially proposed, the SEC nevertheless adopted many of the proposals or modified versions, including rules and amendments related to restricted activities, preferential treatment, quarterly statements, audits and adviser-led secondary transactions. The agency also adopted amendments to Advisers Act Rule 206(4)-7, the so-called compliance rule, that require all advisers registered with the SEC, regardless of whether they advise private funds, to maintain written documentation of their annual compliance reviews.
The private fund adviser rules substantively regulate several aspects of an adviser’s relationship with a private fund and its investors that have historically been left to the marketplace and to the negotiating process between a private fund adviser and its investors.
While some of the new rules affect only registered investment advisers, others would affect exempt reporting advisers, state-registered investment advisers and unregistered investment advisers. In the adopting release, the SEC clarified the scope of the new rules, noting that none of the private fund adviser rules would apply to advisers of securitized asset funds (such as CLOs), solely with respect to such funds.
Further, the SEC clarified that none of the rules would apply with respect to the offshore fund clients of SEC-registered or unregistered offshore advisers (in all cases, regardless of whether those offshore funds have U.S. investors). While the private fund adviser rules affect only advisers that advise private funds, the amendments to the compliance rule apply to all SEC-registered advisers, regardless of whether they advise private funds.
Under the restricted activities rule, an adviser to a private fund may not directly or indirectly with respect to the private fund or any investor in that private fund:
- Charge or allocate to the private fund fees or expenses associated with an investigation of the adviser or its related persons by a governmental or regulatory authority, unless the adviser requests each investor of the private fund to consent to, and obtains written consent from, at least a majority in interest of the private fund’s investors that are not related persons of the adviser for such charge or allocation, provided, however, that the adviser is flatly prohibited from charging or allocating to the private fund fees or expenses associated with an investigation that results or has resulted in a court or governmental authority imposing a sanction for a violation of the Advisers Act or the rules thereunder.
- Charge or allocate to the 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 the investors of such private fund client in writing within 45 days after the end of the fiscal quarter in which the charges occur.
- Reduce the amount of an 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 of such private fund client that sets forth the aggregate dollar amounts of the adviser clawback before and after any reduction for actual, potential or hypothetical taxes within 45 days after the end of the fiscal quarter in which the adviser clawback occurs.
- Charge or allocate fees or expenses related to a portfolio investment (or potential portfolio investment) on a non-pro rata basis when multiple private funds and other 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 adviser distributes to each investor of the private fund a written notice of the non-pro rata charge or allocation and a description of how it is fair and equitable under the circumstances.
- Borrow money, securities or other private fund assets or receive a loan or an extension of credit, from 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.
The rule contains a grandfathering provision that states the disclosure/consent requirements associated with 1 and 5 above do not apply to contractual agreements governing a private fund (or agreements governing a borrowing, loan or extension of credit entered into by a private fund) that has commenced operations as of the compliance date of the restricted activities rule if such contractual agreements would need to be amended to comply with these provisions of the restricted activities rule. The restricted activities rule specifically states, however, that the grandfathering provision does not permit an adviser to a private fund to charge or allocate to the 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 the rules promulgated thereunder.
The SEC adopted companion amendments to Advisers Act Rule 204-2 (the so-called books and records rule) in connection with the restricted activities rule that require advisers to retain copies of all written notifications, consents or other documents distributed or received pursuant to the restricted activities rule, along with a record of each addressee and the corresponding date(s) such documents were distributed by the adviser.
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New Advisers Act Rule 211(h)(2)-3, the preferential treatment rule, restricts advisers from engaging in certain practices with respect to a private fund that favor certain investors over others, except under certain circumstances as described below. The version of the preferential treatment rule that was adopted is substantially similar to the version that was proposed and thus represents a profound shift from current practice in the private fund industry.
The preferential treatment rule, like the restricted activities rule, contains a grandfathering provision that states certain provisions of the preferential treatment rule shall not apply to contractual agreements governing a private fund that has commenced operations as of the compliance date of the preferential treatment rule and that were entered into in writing prior to the compliance date if compliance with such rules would require the parties to amend such governing agreements.
New Advisers Act Rule 211(h)(1)-2, the quarterly statement rule, requires any adviser to one or more private funds that is registered or required to be registered with the SEC to prepare a quarterly statement that includes certain information regarding fees, expenses and performance for any private fund that it advises.
Fee and expense disclosure
The quarterly statement rule requires registered private fund advisers to present information in quarterly statements in a standardized tabular format that discloses things like detailed accounting of all compensation and fees, as well as offsets and rebates. To the extent that a given fund expense could be characterized as adviser compensation under the rule, it requires a registered private fund adviser to disclose the payment or allocation as adviser compensation and not as a fund expense in the quarterly statement.
In addition to adviser compensation, fund expenses and rebates, registered private fund advisers are required to provide a detailed accounting of all portfolio investment compensation allocated or paid to the registered private fund adviser or any of its related persons by a covered portfolio investment during the reporting period (covered portfolio investment requirement). This information must be presented with separate line items for each category of allocation or payment, reflecting the total dollar amount, presented both before and after the application of any offsets, rebates or waivers.
The rule establishes performance reporting requirements for private funds, which differ depending on whether a private fund is a liquid fund or an illiquid fund. Illiquid fund is defined as a private fund that is not required to redeem interests upon an investor’s request and has limited opportunities, if any, for investors to withdraw before termination of the private fund. A liquid fund is defined as any private fund that is not an illiquid fund. The SEC states that liquid funds generally allow periodic investor redemptions (whether monthly, quarterly or semiannually) and primarily invest in market-traded securities and therefore determine their net asset value regularly.
The quarterly statement rule requires an adviser to a liquid fund to show performance based on net total return on an annual basis, over prescribed time periods and on a quarterly basis for the current year. For illiquid funds, the quarterly statement rule requires an adviser to show performance based on the internal rate of return and a multiple of invested capital, on both a net and a gross basis.
A quarterly statement that complies with the performance disclosure requirements of the quarterly statement rule, contains no other information and is sent only to existing private fund investors generally will not be an “advertisement” under Advisers Act Rule 206-4(1) (the so-called marketing rule). However, if a quarterly statement also is an “advertisement,” under the marketing rule, the internal rate of return and multiple of invested capital for the realized and unrealized portions of an illiquid fund’s portfolio must comply with the extracted performance and net performance requirements of the marketing rule.
Preparation and distribution of quarterly statements
In response to concerns from commenters, the quarterly statement rule, as adopted, differentiates between “funds of funds” and all other private funds with respect to the timing of quarterly statement distribution. The quarterly statement rule requires quarterly statements to be prepared and distributed to investors in private funds that are not funds of funds within 45 days after the first three fiscal quarter ends of each fiscal year and 90 days after the end of each fiscal year. Advisers to funds of funds must prepare and distribute quarterly statements within 75 days after the first three fiscal quarter ends of each year and 120 days after the fiscal year-end. For a newly formed private fund, the quarterly statement rule requires registered private fund advisers to prepare and distribute a quarterly statement after the private fund has two full calendar quarters of operating results and continuously each calendar quarter thereafter.
Consolidated reporting for certain fund structures
The quarterly statement rule requires registered private fund advisers to consolidate reporting for similar pools of assets to the extent doing so would provide more meaningful information to the private fund’s investors and would not be misleading. This requires an adviser to a private fund that utilizes a master-feeder structure to provide feeder fund investors with a single quarterly statement covering the applicable feeder fund and the feeder fund’s proportionate interest in the master fund on a consolidated basis, so long as the consolidated statement would provide more meaningful information to investors and would not be misleading. Certain commenters requested more guidance regarding when consolidated reporting would be required; however, the SEC declined to make the rule more prescriptive or provide guidance and retained the proposed principles-based approach. In the proposal, the SEC requested comments regarding whether the quarterly statement rule should require investor-specific or class-specific reporting in addition to fund-level reporting. In adopting the quarterly statement rule, the SEC determined that such granular reporting was not essential to the rulemaking and did not require such detailed reporting.
Format and presentation standards
The quarterly statement rule requires a registered private fund adviser to use clear, concise, plain English in its quarterly statement. Any information that an adviser chooses to include in a quarterly statement that is not required to be included, must be as short as practicable, not more prominent than the required information and not serve to obscure or impede an investor’s understanding of the mandatory information. In addition, the quarterly statement rule requires an adviser to present information in the quarterly statement in a format that facilitates review from one quarterly statement to the next.
The format and content requirements apply to each element of a quarterly statement, including the requirement to disclose the manner in which expenses, payments, allocations, rebates, waivers and offsets are calculated and to cross-reference sections of the private fund’s organizational and offering documents.
Recordkeeping associated with quarterly statements
The SEC adopted certain companion amendments to the Books and Records Rule to require registered private fund advisers to retain books and records related to the quarterly statement rule. These amendments require registered private fund advisers to:
- Retain a copy of any quarterly statement distributed to fund investors, as well as a record of each addressee and the date(s) the statement was sent.
- Retain all records evidencing the calculation method used for all expenses, payments, allocations, rebates, offsets, waivers and performance listed on any quarterly statement delivered.
- Make and keep books and records substantiating the adviser’s determination that the private fund it manages is a liquid fund or an illiquid fund.
Private fund adviser audits
New Advisers Act Rule 206(4)-10 (the audit rule) requires registered private fund advisers to obtain an annual audit of the financial statements of the private funds they advise, directly or indirectly. The SEC adjusted the requirements of the audit rule from the proposal after commenters expressed concerns regarding the overlapping and inconsistent standards between the requirements of Rule 206(4)-2 under the Advisers Act (the custody rule) and the proposed audit rule. To address these concerns, the version of the rule adopted by the SEC requires registered private fund advisers to cause their private funds to undergo audits in accordance with the audit provision (and related requirements) of the custody rule.
Similar to the proposal, if an adviser does not control the private fund and is neither controlled by nor under common control with the fund, the audit rule requires the adviser to take all reasonable steps to cause its private fund client to undergo an audit that would satisfy the audit rule.
The SEC adopted certain companion amendments to the books and records rule that require an adviser to keep a copy of any audited financial statements, along with a record of each addressee and the corresponding date(s) the statements were sent. An adviser to a private fund that it is not in a control relationship with would be required to keep a record documenting the steps the adviser took to cause the private fund client to undergo a financial statement audit that would comply with the audit rule.
In a notable departure from the proposal, the final audit rule does not require an adviser to enter into, or cause the private fund to enter into, a written agreement with the independent public accountant performing the audit requiring it to notify the SEC (i) promptly upon issuing an audit report to the private fund that contains a modified opinion and (ii) within four business days of resignation or dismissal from, or other termination of, the engagement, or upon removing itself or being removed from consideration for being reappointed.
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New Advisers Act Rule 211(h)(2)-2 (the adviser-led secondaries rule) sets forth certain requirements in connection with an adviser-led secondary transaction, which is defined as any transaction initiated by the adviser or any of its related persons that offers private fund 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.
An adviser generally would be viewed as initiating an adviser-led secondary transaction if it commenced a process, or caused one or more other persons to commence a process, that was designed to offer private fund investors the option described above to obtain liquidity for their private fund interests. An adviser would not generally be viewed as initiating an adviser-led secondary transaction if the adviser, at the unsolicited request of the investor, assisted in the secondary sale of such investor’s fund interest or if the adviser conducted a tender offer for fund interests.
The rule requires a registered private fund adviser, prior to the due date of the election form for the adviser-led secondary transaction, to (i) obtain and distribute a fairness opinion or valuation opinion from an independent opinion provider and (ii) prepare and distribute a written summary of any material business relationships the adviser or any of its related persons have, or have had within the two-year period immediately prior to the issuance of the fairness opinion or valuation opinion, with the independent opinion provider.
A fairness opinion is 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. A valuation opinion is a written opinion stating the value (as a single amount or a range) of any assets being sold as part of an adviser-led secondary transaction. Under the proposal, advisers did not have the option of obtaining and distributing a valuation opinion. Several commenters expressed concerns regarding the costs associated with obtaining a fairness opinion. In considering these comments, the SEC reiterated its belief that a third-party opinion was essential to address the conflicts of interest inherent in an adviser-led secondary transaction, but it acknowledged that a valuation opinion (which may cost less to prepare) also would be appropriate and would provide investors with a strong basis to make an informed decision regarding the adviser-led secondary transaction.
In connection with the adviser-led secondaries rule, the SEC adopted certain companion amendments to the books and records rule that require registered private fund advisers to retain a copy of the fairness or valuation opinion and material business relationship summary distributed to investors, as well as a record of each addressee and the date(s) the opinion was sent.
Written documentation requirement for all registered investment advisers’ annual reviews of compliance programs
The amendments to the Compliance Rule were adopted as proposed and generally will require SEC-registered investment advisers (including those that do not manage any private funds) to document in writing the annual review of their compliance policies and procedures. The SEC states that it has found that some advisers do not make and preserve written documentation of the annual review of their compliance policies and procedures. According to the SEC, its examination staff relies on documentation of the annual review to help it understand an adviser’s compliance program, determine whether the adviser is complying with the Compliance Rule and identify potential weaknesses in the compliance program.
Consistent with the proposal, the new amendments do not enumerate particular elements that advisers must include in the written documentation of their annual review. The SEC stated that the written documentation requirement is intended to be flexible to allow advisers to continue to use the review procedures they have developed and found most effective.
Effective and compliance dates
The new rules are scheduled to take effect in just over two months, notwithstanding the legal challenges the agency is currently facing. Also, the SEC’s interpretations regarding how an adviser’s fiduciary duty applies to its private fund clients are effective immediately.
Compliance with the restricted activities rule, preferential treatment rule and adviser-led secondaries rule will be required within 12 months for advisers with $1.5 billion or more in private fund assets under management and within 18 months for advisers with less than $1.5 billion in private fund assets under management.
Compliance with the quarterly statement rule and audit rule will be required within 18 months, compliance with the amendments to the compliance rule is required on the effective date.
While the final private fund adviser rules are not as burdensome as originally proposed, they still represent a seismic shift for the private fund industry, and many believe that the rules will have negative effects on investors in private funds. As the Managed Fund Association said in its lawsuit filing against the changes, “[t]he Private Fund Adviser rule will harm investors, fund managers, and markets by increasing costs, undermining competition, and reducing investment opportunities for pensions, foundations, and endowments.” Even though the rules are being challenged in court, advisers should begin preparing their firms for the rules to take effect. Preparation for compliance with these rules will require extensive planning and cooperation from all departments of an investment adviser.