SEC Proposes Significant Regulatory Changes for Investment Advisers and Private Funds

The U.S. Securities and Exchange Commission (SEC) has proposed rules that would significantly overhaul the regulation of the private fund industry, if adopted. On February 9, 2022, the SEC proposed sweeping new rules, rule amendments, and a new Form ADV-C under the Investment Advisers Act that seek to further regulate investment advisers to private funds in a significant way. Because the proposed rules do not contain any grandfathering provisions, if adopted in their current form, they would apply to existing governing agreements in addition to those entered following the effective date.

Furthermore, while some of the proposed rules would only be mandated for investment advisers, other rule changes would be mandated for SEC-registered and unregistered investment advisers alike (including SEC-registered investment advisers, SEC and state exempt reporting advisers, state-registered investment advisers, and any other investment advisers not registered with the SEC). The following includes a high-level look at key provisions of the proposed rules.

Quarterly Statements

Currently, private fund advisers are not subject to investor reporting requirements under the Investment Advisers Act. The proposed rules would require a registered private fund adviser to prepare a quarterly statement for each private fund that it advises (directly or indirectly) that has at least two full calendar quarters of operating results.

Within 45 days of the calendar quarter end, the adviser would be required to distribute a quarterly statement to investors, unless the quarterly statement is prepared and distributed by another person. The quarterly statement would be required to include: a fund table, a portfolio investment table, prominent disclosure, performance data regarding whether the fund is a liquid or illiquid fund, and consolidated reporting to cover substantially similar pools of assets if meaningful.

Investment Adviser-Led Secondaries

As it relates to certain adviser-led secondary transactions, the proposed rules would require registered private fund advisers to provide to investors a fairness opinion from an independent opinion provider opining on the fairness of the price being offered to the private fund for any assets being sold as part of the transaction. The proposed rules also require the adviser to prepare and distribute a written summary of certain material business relationships between the adviser and the opinion provider.

Private Fund Audit Requirement

Registered private fund advisers would be required to obtain an audited financial statement of each private fund annually and upon liquidation (similar to the custody rule) and distribute the audited financial statements to investors “promptly” after the audit’s completion. In addition, a fund’s auditor would be required to notify the SEC upon the auditor’s termination or issuance of a modified opinion. The Commodity Futures Trading Commission (CFTC) has similar requirements, but its regulations impose a timeline for distribution (90 days of the pool’s fiscal year end) and further require a Commodity Pool Operator (CPO) to file the annual report containing audited financial statements with the National Futures Association.

Preferential Treatment

The proposed rules would prohibit all private fund advisers from providing certain types of preferential treatment that have a material, negative effect on other investors, while also prohibiting all other types of preferential treatment unless disclosed to current and prospective investors. This includes preferential treatment related to investor redemptions, transparency about portfolio holdings or exposures, and fees.

This would greatly affect investment advisers’ use of “side letters.” Under the proposed rule, an adviser would need to describe specifically the preferential treatment to convey its relevance. The SEC stated specifically that mere disclosure that some investors pay a lower fee than others in exchange for a significantly higher capital contribution than paid by others, for example, is not specific enough. The SEC stated that the adviser must describe the lower fee terms, including the applicable range in order to provide specific information required by the proposed rules. An investment adviser could comply with this disclosure requirement by providing copies of side letters or a written summary of the preferential terms provided to other investors in the same private fund. Without a “grandfathering” provision, this provision would force advisers to choose between complying with the new proposed rules or breaching a previously granted side letter provision.

Prohibited Practices

The proposed rules would prohibit private fund advisers, including those that are not currently registered with the SEC (e.g., exempt reporting advisers), from the following:

• charging a private fund or portfolio company monitoring, servicing, consulting, or other fees for any services the adviser does not, or does not reasonably expect to, provide to the entity;
• charging the private fund fees or expenses associated with an examination or investigation of the adviser or related person by any government or regulatory authority;
• charging the private fund for any regulatory or compliance fees or expenses of the adviser or related person;
• charging or allocating fees and expenses related to a portfolio company on a non-pro rata basis when multiple private funds and other clients of the adviser have invested (or proposed to invest) in the same portfolio company;
• seeking reimbursement, indemnification, exculpation, or limitation of its liability by the private fund or its investors for a breach of fiduciary duty, willful malfeasance, bad faith, negligence, or recklessness in providing services to the fund;
• borrowing money, securities, or other assets or receiving a loan from the private fund client; and
• reducing the amount of any clawback by actual, potential, or hypothetical taxes applicable to the adviser or related person.

Written Annual Review of Compliance Programs

Currently, there is no SEC requirement for advisers to document the annual review of their compliance policies and procedures. The proposed rules would require written documentation that an annual review was completed for all registered advisers, including advisers that do not manage private funds.

Cybersecurity Risk Management

Investment advisers would be required to implement written policies and procedures that are reasonably designed to address cybersecurity risks according to general elements listed in the cybersecurity rule. Registered advisers also would need to report descriptions of all cybersecurity incidents that have occurred within the prior two fiscal years that have significantly disrupted or degraded their ability to maintain critical operations, or have led to the unauthorized access, or use of, adviser information. In addition, advisers would be required to submit new Form ADV-C within 48 hours after having a reasonable basis to conclude that a significant adviser cybersecurity incident or a significant fund cybersecurity incident has occurred as required by new Advisers Act Cybersecurity Incident Reporting Rule.

Conclusion

The SEC’s new proposals have the potential to significantly affect private fund investment advisers and private funds, forcing investment advisers to private funds to think about future compliance issues. We emphasize that these proposed rules are still subject to public comment before any final rules are adopted. We expect many comments to be submitted. The SEC is proposing a one-year transition period after final rules are adopted to provide time for investment advisers to come into compliance with the new regulations.