On August 23, the Securities and Exchange Commission (SEC) passed a final rule significantly increasing oversight and expanding compliance obligations for all private fund advisers, including exempt reporting advisers (ERAs) who have historically been exempt from some of the more rigorous compliance and reporting requirements applicable to private fund advisers.
The 660-page final rule will have a broad and significant impact on the private fund adviser space. Look for additional guidance as we continue to review the nuanced language of this rule, generally, and how it applies to our clients, specifically.
The SEC’s adopting release identifies the following new requirements, with some rules applicable only to SEC-registered private fund advisers, and others applicable to all private fund advisers, including ERAs, as indicated:
1. Quarterly Statement Rule: All SEC-registered private fund advisers must provide investors with quarterly statements containing information about private fund fees, expenses and performance. Other than with respect to a private fund that is a fund of funds, quarterly statements must be distributed 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. For private funds that are a fund of funds, a slightly longer timeline applies.
2. Audit Requirement Rule: All SEC-registered private fund advisers must arrange for a Public Company Accounting Oversight Board (PCAOB) annual audit related to each fund the adviser manages consistent with the requirements in Rule 206(4)-2 of the Investment Advisers Act of 1940 (the “custody rule”).
3. Adviser-led Secondaries Rule: All SEC-registered private fund advisers conducting an adviser-led secondary transaction must obtain a fairness opinion or a valuation opinion from an “independent opinion” provider. Additionally, such advisers must also prepare and distribute a written summary of any material business relationships between the adviser or its related persons and the independent opinion provider.
4. Restricted Activities Rule: The following five requirements apply to all private fund advisers, including ERAs:
- Pass Through of Regulatory Investigation Costs. The adviser can only 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 if the adviser obtains written consent from a majority of the private fund’s investors that are not related persons of the adviser. However, under no circumstances can the adviser charge or allocate fees and expenses related to an investigation that results or has resulted in sanctions for violating the Investment Advisers Act of 1940 or the rules promulgated thereunder.
- Pass Through of Regulatory or Compliance Costs. The adviser can only charge or allocate to the private fund regulatory or compliance fees and expenses associated with an examination of the adviser or its related persons if the adviser provides after-the-fact disclosures on a quarterly basis, detailing the fees and expenses to investors.
- Reduced Clawbacks. The adviser may only participate in after-tax adviser clawback reductions if the adviser satisfies after-the-fact disclosure requirements designed to better inform private fund investors of the impact of the reductions.
- Charges or Fees Related to a Portfolio Investment. The adviser may only charge or allocate fees and 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, if (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 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.
- Borrowing from Private Fund Clients. The adviser may only borrow from a private fund client if the adviser distributes advanced, written notice and a description of the material terms of the borrowing to the investors of the private fund, seeks their consent for the borrowing and obtains written consent from at least a majority in interest of the fund’s investors that are not related persons of the adviser.
5. Preferential Treatment Rule: This rule prohibits private fund advisors from giving preferential treatment to investors. Prohibited activities include:
- Redemption Rights. The rule will prohibit all private fund advisers, including ERAs from offering preferential redemption rights to certain investors, such as those commonly offered in side letter agreements, if such rights could have a material negative effect, with two exceptions: (i) those permitted by law, rule or order or (ii) if the adviser has offered the same redemption availability to all investors and will continue to offer it to all investors.
- Information Rights. The rule will prohibit all private fund advisers, including ERAs, from providing preferential information regarding portfolio holdings or exposures of the fund or a similar pool of assets that will have a material, negative effect on other investors in that private fund or the similar pool of assets unless the information is offered to all fund investors and the adviser provides the necessary disclosure.
This rule includes a disclosure requirement. The adviser will be required to give advanced, written notice of material economic terms and any preferential treatment that will impact investors.
6. Annual Review Rule: The rule amends Investment Advisers Act rule 206(4)-7 (the “compliance rule”) to require all SEC-registered advisers – even those that do not advise private funds – to document their annual compliance program reviews in writing.
7. Books and Records Rule: The rule amends the Investment Advisers Act recordkeeping rule to require advisers to retain books and records documenting the adviser’s compliance with the rule.
The SEC is providing legacy status (i.e., “grandfathering”) for various aspects of the rule. For example, legacy status will apply under the prohibited activities aspect of the preferential treatment rule (i.e., the rules regarding redemption rights and information rights will not apply to existing written contractual agreements governing private funds that commenced operation prior to the rule’s compliance date, nor will they apply to side letters or other similar agreements that were entered into prior to the compliance date).
The rule also provides legacy status for the aspects of the restricted activities rule that require investor consent. However, legacy status will not apply to the aspects of the restricted activities rule with disclosure-based exceptions.
For the audit rule and the quarterly statement rule, the SEC adopted an 18-month transition period for all private fund advisers.
For the adviser-led secondaries rule, the preferential treatment rule and the restricted activities rule, the SEC adopted staggered compliance dates based on an adviser’s size. Small advisers with less than $1.5 billion in private funds assets (“smaller private fund advisers”), will have an 18-month transition period, compared to 12 months for large advisers.
Compliance with the annual review rule will be required 60 days after its publication in the Federal Register.
For questions regarding the SEC’s final rule or its application to your business, including conducting and documenting annual compliance program reviews, please contact a member of Warner’s Funds and Investments Industry Group. We look forward to communicating additional, detailed guidance related to the rule.