On August 23, 2023, the SEC adopted new rules under the Investment Advisers Act of 1940 (the “Advisers Act”).  While certain of the rules apply only to SEC-registered investment advisers, others apply to all investment advisers to private funds, regardless of registration status.  The new rules include (1) requirements to deliver specified information to investors on a quarterly basis, (2) a requirement that SEC-registered investment advisers cause each private fund that they advise to undergo an annual audit, (3) specific requirements for adviser-led secondary transactions, (4) restrictions on certain activities by advisers to private funds (subject to disclosure and/or consent exceptions in some cases), (5) restrictions on offering preferential redemption and information rights to fund investors (subject to certain exceptions) and a requirement to disclose all preferential terms granted, and (6) a requirement for SEC-registered investment advisers to document their annual compliance reviews in writing.  Advisers registered or required to be registered with the SEC will be subject to various additional recordkeeping requirements to demonstrate compliance with the rules.  This alert describes the new rules and their compliance dates in greater detail.

1. The Quarterly Statement Rule

Each investment adviser that is registered or required to be registered with the SEC must prepare a quarterly statement for any private fund advised by the adviser that has at least two fiscal quarters of operating results.  Such quarterly statement must be delivered within 45 days after the end of the first three fiscal quarters of the year, and within 90 days after the end of the fiscal year.  Advisers to funds of funds may deliver the quarterly statement with respect to a fund of funds within 75 days after the end of each fiscal quarter and within 120 days after the end of the fiscal year.  

The quarterly statement must include:

• A table listing for the applicable period (1) all compensation, fees, and other amounts allocated or paid to the investment adviser or its related persons by the private fund, (2) all fees and expenses allocated to or paid by the private fund (other than those listed in (1)), and (3) the amount of any offsets or rebates carried forward to subsequent periods to reduce future payments or allocations to the adviser or its related persons (in the case of (1) and (2), the information must be presented both before and after the application of any offsets, rebates, or waivers); 

• A separate table with respect to the private fund’s portfolio investments listing portfolio investment compensation paid to the adviser or its related persons by the portfolio investment;

• For an illiquid fund (generally, a private fund that is not required to redeem investors’ interests upon request and that provides limited opportunities for investors to withdraw), gross and net IRR and gross and net MOIC (multiple of invested capital) calculations for the fund, and a statement of contributions and distributions for the fund; and

• For a liquid fund (generally, a private fund that allows redemptions), annual net total returns for each fiscal year over the past 10 fiscal years or since inception (whichever is shorter), average annual net total returns over one-, five-, and 10-fiscal-year periods, and the cumulative net total return for the current fiscal year as of the end of the most recent fiscal quarter.

The adviser is required to consolidate the quarterly reports of a fund with any similar pool of assets (e.g., consolidating information of a master fund and its feeder funds) if doing so would provide more meaningful information to investors and would not be misleading.  

2. The Audit Rule

Each investment adviser that is registered or required to be registered with the SEC must cause each private fund that it advises (other than any securitized asset fund) to undergo an audit that meets the requirements of the “custody rule” under the Advisers Act (including that the auditor must meet independence requirements and be subject to examination by the PCAOB, and the audited financial statements must be prepared in accordance with GAAP).  The adviser must deliver the audited financial statements to each investor in the applicable fund within 120 days after the end of each fiscal year and promptly upon liquidation of the fund.  If the adviser is a subadviser to a private fund that the adviser does not control, the adviser must take all reasonable steps to cause the fund to undergo an audit that meets the aforementioned requirements.

While many private funds are already audited on an annual basis, funds that currently undergo a “surprise examination” in lieu of an audit in order to comply with the custody rule will need to undergo an audit to comply with the new rule.
 

3. The Adviser-Led Secondaries Rule

In connection with any adviser-led secondary transaction, an adviser that is registered or required to be registered with the SEC must (a) obtain and distribute to investors in the applicable private fund either a valuation opinion or a fairness opinion issued by an independent third party and (b) prepare and distribute to investors in the private fund a written summary of any material business relationships between the adviser or any of its related persons and the opinion giver within the 2-year period immediately prior to the issuance of the opinion.  Such materials must be distributed to the fund’s investors prior to the due date of the election form for the applicable transaction.

An “adviser-led secondary transaction” is any transaction initiated by the investment adviser or any of its related persons that offers private fund investors the choice between: (1) selling all or a portion of their interests in the private fund and (2) 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.  Per the rule’s authorizing release, an unsolicited request by an investor to sell its fund interest in a secondary transaction generally would not be considered an adviser-led secondary transaction.  Also, tender offers generally will not fall within the rule if investors are permitted to retain their interest in the same fund with respect to the asset that is the subject of the transaction on the same terms (i.e., the investor is not required to either sell its interest or convert its interest to an interest in another vehicle as part of the transaction).

4.    The Restricted Activities Rule

Any adviser to a private fund is prohibited from engaging in the following activities, subject to the exceptions described below.

• The adviser may not charge or allocate to a private fund fees or expenses associated with an investigation of the adviser or its related persons by a governmental or regulatory authority without the consent of a majority in interest of unaffiliated investors in the fund.  Notwithstanding the foregoing, the adviser may not charge or allocate to a private fund any fees or expenses related to an investigation that has resulted in sanctions on the adviser for a violation of the Advisers Act.

• The adviser may not charge or allocate to a private fund regulatory or compliance fees or expenses, or fees and expenses associated with an examination of the adviser or its related persons, unless the adviser delivers a notice of such fees and expenses (including the dollar amount thereof) to the investors in the fund within 45 days after the end of the fiscal quarter in which the charge is incurred.

• The adviser may not reduce a clawback payment by actual, potential, or hypothetical taxes applicable to the adviser, its related persons, and their respective interest holders, unless the adviser delivers a written notice to the investors in the applicable private fund that sets forth the dollar amount of the clawback payment both before and after taxes within 45 days after the end of the fiscal quarter in which the clawback occurs.

• When multiple vehicles advised by the adviser invest or propose to invest in the same portfolio investment, the adviser may not charge or allocate fees or expenses relating to such portfolio investment on a non-pro rata basis unless (1) the non-pro rata charge or allocation is fair and equitable under the circumstances and (2) prior to charging or allocating such expenses on a non-pro rata basis, the adviser delivers to each investor in the applicable private fund a written notice of the non-pro rata charge and a description as to how it is fair and equitable.

• The adviser may not borrow money or other assets from, or receive a loan or extension of credit from, a private fund it advises, unless the adviser (1) delivers to each investor in the fund a description of the material terms of the borrowing and (2) obtains consent from at least a majority in interest of unaffiliated investors in the fund.

As the restricted activities described above apply to all investment advisers to private funds, whether or not the adviser is registered with the SEC, exempt reporting advisers, state-registered advisers, and advisers to private funds who are not otherwise registered are required to comply with this rule.
 

5.    The Preferential Treatment Rule
 

The new rules restrict advisers from granting preferential rights to investors in a private fund (subject to certain exceptions and disclosure requirements).  Such rights are typically provided through side letters or similar agreements, although the rule is not limited to preferential rights granted through side letters.  Under the rule, any adviser to a private fund may not:

• Grant an investor in the private fund or a similar pool of assets the ability to redeem its interest on terms that the adviser reasonably expects to have a material, negative effect on other investors in that private fund or in a similar pool of assets, except:

  • If the ability to redeem is required by applicable laws, rules, regulations, or orders of any relevant government to which the investor, the private fund, or the similar pool of assets is subject; or

  • If the adviser has offered the same redemption rights to all other investors, and will continue to offer such rights to all future investors in the private fund and any similar pool of assets.  A “similar pool of assets” is broadly defined under the rule and includes pooled investment vehicles managed by the adviser or its related persons that have substantially similar investment policies, objectives, or strategies as the applicable fund.

• Provide information about the holdings or exposures of the private fund or a similar pool of assets to any investor in the private fund if the adviser reasonably expects that providing the information would have a material, negative effect on other investors in the private fund or in a similar pool of assets, unless the adviser offers the information to all other existing investors in the private fund and any similar pool of assets at the same time or substantially the same time.

The foregoing restrictions will not apply to contractual agreements governing a private fund that has commenced operations as of the compliance date and that were entered into in writing prior to the compliance date if the parties would be required to amend such contractual agreements in order to comply with the rule.  Thus, any existing side letters or similar agreements or preferential rights set forth in a fund’s existing governing documents will not be affected by the new rules.  

In addition, an adviser may not provide any preferential treatment to an investor in a private fund, unless:

• The adviser provides to each prospective investor, prior to such investor’s investment in the fund, a written notice with specific information regarding any preferential treatment related to material economic terms (such as fees, performance allocations, liquidity terms, and co-investment rights) provided to other investors in the fund; and

• The adviser delivers to each existing investor written disclosure of all preferential treatment that the adviser or a related person has provided to other investors in the fund.  For an illiquid fund, the disclosure must be delivered as soon as reasonably practicable following the end of the fund’s fundraising period.  For a liquid fund, the disclosure must be delivered as soon as reasonably practicable following the investor’s investment in the fund.  An updated disclosure must be provided to investors at least annually if any new preferential terms have been granted since the last written notice.  

This rule effectively prevents advisers and fund general partners from keeping side letter terms confidential.  While redacting identifying information associated with other investors is permissible, the substantive provisions of each side letter or similar agreement will need to be disclosed to all investors in a private fund.  Further, advisers will now be required to make pre-closing disclosures to prospective investors regarding material economic terms previously granted.  This is a significant departure from the practices of most private funds, and advisers will need to be prepared to compile and disclose any such material economic side letter terms to subsequent closing investors before they commit to invest in the fund.   

As is the case with the restricted activities rule, the preferential treatment rule applies to all investment advisers to private funds, whether or not the adviser is registered with the SEC.  Thus, exempt reporting advisers, state-registered advisers, and advisers to private funds who are not otherwise registered are required to comply with these rules.\

6.    The Annual Review Rule

Advisers registered or required be registered with the SEC are required to review and document in writing, no less frequently than annually, the adequacy of their compliance policies and procedures and the effectiveness of their implementation.  SEC-registered investment advisers are already required to review their compliance policies and procedures annually, and many advisers likely have been maintaining written documentation related thereto.  To the extent an adviser is not already doing so, the adviser should be prepared to document its next annual review in writing.

7.    Compliance Dates and Grandfathering

The quarterly statement rule and the audit rule will become effective 18 months after publication of the new rules in the Federal Register.  The adviser-led secondaries rule, the preferential treatment rule, and the restricted activities rule will become effective (1) for advisers with $1.5 billion or more in private fund assets under management, 12 months after publication in the Federal Register, and (2) for advisers with less than $1.5 billion in private fund assets under management, 18 months after publication in the Federal Register.  The annual review rule will become effective 60 days after publication in the Federal Register.

The prohibitions on (1) an adviser charging or allocating expenses associated with an investigation to a private fund without investor consent and (2) an adviser borrowing from a private fund client without investor consent will not apply with respect to contractual agreements entered into prior to the compliance date to the extent that the relevant contractual agreements would need to be amended in order to comply with the rule.  Notwithstanding the foregoing, the prohibition on an adviser charging or allocating fees or expenses to a private fund related to an investigation that has resulted in sanctions on the adviser for a violation of the Advisers Act is not grandfathered, so no such costs may be charged to a private fund after the compliance date.

Also, as noted above, the prohibitions on providing preferential redemption rights and preferential information rights to certain investors will not apply to contractual agreements governing a private fund that has commenced operations as of the compliance date and that were entered into in writing prior to the compliance date if the parties would be required to amend such contractual agreements in order to comply with the rule.

Conclusion

The new rules are complex and will require changes in practices and procedures for many private funds and their investment advisers.  All investment advisers (regardless of registration status) should begin preparations as soon as practicable in order to ensure that the private funds they advise will be in compliance with the new rules by the end of the applicable transition periods.