SEC Adopts New Rules for Private Funds: What Advisers and Investors Need to Know

On August 23, 2023, the U.S. Securities and Exchange Commission (“SEC” or “Commission”) finalized new rules and amendments under the Investment Advisers Act of 1940 (“Advisers Act”) to enhance the regulation of private fund advisers. According to the SEC, these new rules are intended to increase transparency, competition, and efficiency in the private funds sector. 

The new rules represent a significant overhaul for the industry. However, the final regulations were not as sweeping as some observers feared, omitting or modifying a few of the more controversial proposals. These changes followed strong pushback from industry participants who argued that the Commission was overreaching its authority. For example, the final rules do not prohibit limiting a private fund adviser’s liability for certain misconduct or ban arrangements that grant certain investors special terms.¹ Nonetheless, despite these apparent concessions, the new rules will have a dramatic impact on advisers and investors.

The new requirements include the following rules:

• Quarterly Statement Rule: SEC-registered private fund advisers must provide investors with quarterly statements disclosing information on fund performance, fees and expenses, and certain compensation or other amounts paid to the adviser.
• Private Fund Audit Rule: SEC-registered private fund advisers are now required to have the private funds they advise undergo a financial statement audit that meets the requirements of the audit provision in the Advisers Act custody rule. 
• Adviser-Led Secondaries Rule: SEC-registered private fund advisers must obtain a fairness opinion or a valuation opinion when offering investors the option between selling their interests in a private fund and converting or exchanging their interests in that fund for interests in another vehicle advised by the adviser or any of its related persons. This rule also requires the adviser to prepare and distribute to the fund’s investors a summary of any material business relationships the adviser has, or has had within the last two years, with the independent opinion provider.
• Restricted Activities Rule: All private fund advisers must refrain from engaging in the following activities, unless the adviser discloses the activity to the private fund investors and, for certain activities, obtains investors’ consent:²
  • Charging or allocating to the private fund fees or expenses associated with an investigation of the adviser; however, regardless of disclosure, an adviser may not charge fees or expenses related to an investigation that results or has resulted in a court or governmental sanction for a violation of the Advisers Act or the rules promulgated thereunder; 
  • Charging or allocating to the private fund regulatory, examination, or compliance fees or expenses of the adviser; 
  • Reducing the amount of an adviser clawback by the amount of certain taxes;
  • Charging or allocating fees or expenses related to a portfolio investment on a non-pro rata basis, unless the allocation approach is fair and equitable; and 
  • Borrowing or receiving an extension of credit from a private fund client.
• Preferential Treatment Rule: All private fund advisers are prohibited from providing preferential terms to investors regarding (1) certain redemptions from the fund, unless the ability to redeem is required by applicable law or the adviser offers the preferential redemption rights to all other investors without qualification; and (2) certain preferential information about portfolio holdings or exposures, unless such preferential information is offered to all investors. Additionally, unless certain terms are disclosed prior to an investor’s investment in the private fund and all terms are disclosed thereafter, advisers are prohibited from providing preferential treatment to investors.

Notably, the Commission is providing “legacy status” for the prohibitions of the Preferential Treatment Rule and the aspects of the Restricted Activities Rule that require investor consent. This effectively grandfathers in side-letter agreements entered prior to the compliance date if the applicable rule would require the parties to amend their contractual agreements. This concession is a response to concerns raised by the industry about the challenges and costs that would arise from retrofitting existing side-letters to be compliant with the new regulations.
 
The new rules follow enforcement actions intended to crack down on the same types of concerns. For example, in the past few months alone, the SEC has announced settled charges against private fund advisers for failing to adopt and implement reasonably designed written policies and procedures concerning the valuation of investments,³ and for failing to disclose conflicts of interest arising from the investment of client assets in special purpose acquisition companies that were affiliated with the adviser’s personnel.⁴ Indeed, the Commission referenced its recent enforcement activity against private fund advisers in the introduction to the new rules, stating that as part of its oversight function “[t]he Commission has pursued enforcement actions against private fund advisers for fraudulent practices related to fee and expense charges or allocations that are influenced by the advisers’ conflicts of interest,” among others.⁵ To that end, private fund advisers should remain vigilant and mindful of these new requirements or risk future enforcement actions.

Even though the final rules are scaled back from the original proposal, they still represent a significant package of rules designed to protect private fund investors. Advisers can reasonably expect the SEC to scrutinize their compliance with these rules and bring enforcement actions arising from any non-compliance. To avoid those risks, in addition to familiarizing themselves with the final rules, advisers should err on the side of making clear disclosures and monitor any guidance from the Commission’s staff in advance of the compliance date.

¹ https://www.sec.gov/files/rules/final/2023/ia-6383.pdf
² The proposed rules did not contain the exception for disclosures and would have flatly prohibited this conduct.
³ https://www.sec.gov/enforce/ia-6315-s 
⁴ https://www.sec.gov/enforce/34-97957-s 
⁵ https://www.sec.gov/files/rules/final/2023/ia-6383.pdf