SEC's New Transparency Rules Target Private Fund Advisers

March 2022

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On Feb. 9, the U.S. Securities and Exchange Commission (SEC) proposed new rules and amendments to the Investment Advisers Act of 1940 directed at private fund advisers. The proposals would provide a statutory mandate for audits of private funds, enhance transparency to investors about the costs of investing in a private fund and the performance of such fund, limit and/or ban certain transactions or activities that represent a conflict of interest for the private fund adviser as well as prohibit certain sales practices that are contrary to the public interest and protection of investors.

The proposal anchors around five central areas, two of which would comprise all private fund advisers (i.e., registered and unregistered private fund advisers).
 

Proposal Affecting Registered Advisers

 

PRIVATE FUND AUDIT RULE

The Private Fund Audit Rule would
  • Registered Advisers to have all of their managed private funds’ financial statements undergo an audit at least annually and upon liquidation
  • Such audits to be conducted in accordance with U.S. generally accepted audit standards (GAAS)
  • Such audits to be performed by an accounting firm that
    • is registered with, and subject to inspection by, the Public Company Accounting Oversight Board (PCAOB)
    • maintains auditor independence in accordance with SEC independence rules
  • Notification by the accounting firm to the SEC
    • any changes in the audit firm (e.g., through resignation, or dismissal)
    • any modified opinion that the accounting firm issues at the completion of the audit


 

QUARTERLY STATEMENT RULE

(Fees and Expenses, and Fund Performance)
Through the quarterly statement rule, the Act proposes to increase transparency of information to investors about the cost of investing in a private fund and the private fund’s performance.

Fees and Expenses: This rule would require registered private fund advisers to distribute to private fund investors a quarterly statement that details, in table format, the following:
  • All compensation, fees and other expenses allocated or paid by the fund to the adviser or to any of its affiliates during the reporting period
  • Other expenses paid by the fund
  • Any offsets, rebates or waivers carried forward during the current reporting period to subsequent quarterly periods to reduce future payments or allocations to the adviser or its affiliates.
The proposed quarterly statement rule would also require advisers to disclose the following information with respect to any covered portfolio investment4 in a single table, as applicable to all such covered portfolio investments:
  • A detailed account of all portfolio investment compensation allocated or paid by each covered portfolio investment during the reporting period
  • The private fund’s ownership percentage of each such covered portfolio investment as of the end of the reporting period. If the fund does not have an ownership interest in the covered portfolio investment, the adviser would be required to list 0% as the fund’s ownership percentage, along with a brief description of the history of the fund’s investment in such covered portfolio investment.
Fund Performance: This disclosure is divided between private funds that are “illiquid” or “liquid” funds.

For illiquid funds, the quarterly statement would be required to have performance information covering the period from inception through the end of the current calendar quarter covered by the statement, including:
  • Gross and net internal rate of return for the fund
  • Gross and net multiple of invested capital for the funds
  • Gross internal rate of return and gross multiple of invested capital for the realized and unrealized portions of the fund’s portfolio, with the realized and unrealized performance shown separately
The proposed rule also would require advisers to provide investors with a statement of contributions and distributions for the illiquid fund, detailing the capital inflows and outflows since inception by date for each cash in(out)flow and the amount of each in(out)cash flow, as well as the net asset value as of the end of the current quarter covered by the statement.
For liquid funds, the quarterly statement would disclose fund performance information that includes
  • Annual net total returns for each calendar year since inception
  • Average annual net total returns over the one, five and ten calendar year periods
  • Cumulative net total returns for the current calendar year as of the end of the most recent calendar quarter covered by the quarterly statement

 

ADVISER-LED SECONDARIES RULE

The proposal would require a registered private fund adviser to obtain a fairness opinion in connection with an adviser-led secondary transaction where the adviser offers fund investors the option to sell their interests in the private fund, or to exchange them for new interests in another of the adviser’s vehicles. An independent opinion provider would opine on the fairness of the price being offered to the private fund for any assets being sold as part of the transaction. The proposal also would require the adviser to prepare and distribute to the private fund investors a summary of any material business relationships the independent opinion provider has or has had within the past two years with the adviser or any of its related persons.


 

Proposals Affecting All Advisers

PREFERENTIAL TREATMENT RULE

The preferential treatment rule eliminates the sales practice by all private fund advisers of providing preferential treatment regarding redemptions from the fund or information about portfolio holdings or exposures to investors. This proposal also prohibits these advisers from providing any other preferential treatment to any investor in the private fund, unless such treatment is disclosed to all current and prospective investors in writing.



However, there are scenarios where the preferential liquidity terms harm the fund and other investors. For example, if an adviser allows a preferred investor to exit the fund early and sells liquid assets to accommodate the preferred investor’s redemption, the remaining investors may be left with a less liquid pool of assets, which can inhibit the fund’s ability to carry out its investment strategy or promptly satisfy other investors’ redemption requests.
 

PROHIBITED ACTIVITIES RULE

The prohibited activities rule is designed to reduce the likelihood of fraud by removing adviser incentives. The proposal would ban private fund advisers from:
  • Charging certain fees and expenses to a private fund or its portfolio investments, such as fees for unperformed services (e.g., accelerated monitoring fees, servicing fees, consulting or other fees)
  • Charging fees associated with an examination or investigation of the adviser
  • Seeking reimbursement, indemnification, exculpation, or limitation of its liability for breach of fiduciary duty, willful misfeasance, bad faith, negligence, or recklessness in providing services to the private fund
  • Reducing the amount of an adviser clawback by the amount of certain taxes
  • Charging fees or expenses related to a portfolio investment on a non-pro rata basis
  • Borrowing or receiving an extension of credit from a private fund client


 

Summary and Takeaway

This SEC proposal comes at a busy time of the year for private fund advisers — and it also comes on the heels of two other rule proposals: the Cybersecurity Risk Management Rule for Advisers and the proposal to amend, and expand the disclosures in, Form PF. While the additional SEC proposed requirements may not represent a seismic shift for large private equity and hedge fund advisers, they may be more consequential for mid-size and smaller private fund advisers. Across the board, the proposed changes to the Act mean that private fund advisers will face more compliance requirements. As a result, compliance and technology departments may need to either bolster their headcount to support and keep up with the additional documentation requirements and monitoring surveillance for compliance or engage external firms to supplement their own resources.

These proposed changes to the Act also reflect a move to boost transparency of costs and performance that are similar to those provided by mutual funds. The proposed standardized information will allow investors to understand the costs of a dollar invested and to evaluate the value derived from such costs through fund performance.

Advisers should closely monitor evolving developments to ensure operational and compliance readiness. Comments and feedback on the proposal are due the later of 30 days after publication in the Federal Register or April 11 (which is 60 days after issuance).