The U.S. Securities and Exchange Commission (the “SEC”) adopted and published its Final Rule Release IA-6383 under the Investment Advisers Act of 1940 (the “Advisers Act”) on August 23, 2023. These rules (the “Final Rules”) are the final version of the rules initially proposed in February 2022 (the “Proposal”). The Final Rules create significant new and onerous requirements for private fund advisers, both registered and unregistered, but are not as restrictive or aggressive as the Proposal. 

The Final Rules impact virtually all categories of investment advisers: registered investment advisers (“RIAs”), state-registered investment advisers and exempt reporting advisers and other unregistered investment advisers with virtually the only explicitly noted exception being advisers to securitized asset funds. The Final Rules impose significant new reporting requirements, prohibitions and disclosure requirements and restrict certain activities.

The SEC issued a combination of five separate rules and one rule amendment: the Quarterly Statements Rule, the Audit Rule, the Adviser Led Secondary Transactions Rule, and the amendment to the Annual Review and Recordkeeping Rule that apply only to RIAs. The Restricted Activities Rule and Preferential Treatment Rule apply to all private fund investment advisers. 

Although many of the requirements are not applicable to private fund investment advisers that are not RIAs under the Final Rules, some of such requirements may still be applicable to them by virtue other laws and regulations and the Final Rules do not exempt investment advisers that are not RIAs from any such requirements. For example, the exempt reporting advisers that are required to comply with the audit requirements by virtue of similar state statutes will continue to be subject to such requirements.

The SEC also narrowly limited the circumstances where existing private funds or private fund advisers receive legacy status that exempts them from requirements of the Final Rules (“Legacy Status”). The specific instances of Legacy Status are discussed below. However, private funds advisers should be cautious in relying on Legacy Status as the circumstances of its application are narrow and fact specific to each private fund and private fund adviser.

The Final Rules also draw a distinction between illiquid funds and liquid funds. Illiquid funds are defined as a private fund that (a) is not required to redeem interests upon an investor’s request and (b) has limited opportunities for investors to withdraw prior to the fund’s termination. (“Illiquid Fund”). Liquid funds are defined as private funds that are not illiquid funds (“Liquid Funds”). We note below where the Final Rules apply differently depending on the liquidity of the fund.

The Final Rules will require material changes to the market practices of private fund advisers and will have a significant impact on the private funds industry. The private funds industry took significant issue with the Proposal and Final Rules prior to their adoption and filed litigation challenging the Final Rules almost immediately upon their adoption. On September 1, 2023, a coalition of private fund industry organizations filed a petition for review pursuant to Section 213(a) of the Advisers Act, which allows for persons “aggrieved” by the SEC to challenge the SEC’s actions. The petition alleges that: 

1. The SEC exceeded its authority and did not follow proper notice-and-comment requirements;
2. The Final Rules are arbitrary and capricious; and 
3. The SEC did not fulfill its obligation to consider the effects on capital formation. 

There is no automatic stay of the Final Rules due to the filing of this petition, and the litigation may or may not impact the Final Rules. We will continue to monitor this and any other litigation regarding the Final Rules. Thus, until any rulings are issued by a court regarding the Final Rules, investment advisers should proceed as if the Final Rules will be fully implemented as currently issued.

The Final Rules will go into effect sixty (60) days after publication in the Federal Register. There are different specific compliance dates with individual rule requirements. While advisers will generally have twelve (12) to eighteen (18) months before they must comply with these requirements (as discussed below), advisers should use this time to develop best practices since it is anticipated the SEC will follow the Final Rules with heightened attention and scrutiny on all private fund adviser activity.

High Level Summary

Included below are high level summaries of each of the new Final Rules. Please refer to the more detailed summaries below for additional information and compliance requirements.

Rules Applying to Only RIAs

• Quarterly Statement Rule – Requires RIAs to distribute quarterly statements to all fund investors. These quarterly statements must include standardized information on the fund’s performance, costs incurred by the fund and expenses paid by the fund.
  
  • No Legacy Treatment
  • Compliance Date¹ – Eighteen (18) months after publication of the Final Rules in the Federal Register.
• Audit Rule – Requires RIAs to cause the private funds they advise to obtain an annual financial statement audit (meeting the audit requirements of the Custody Rule²). 
  
  • No Legacy Treatment
  • Compliance Date – Eighteen (18) months from the publication of the Final Rules in the Federal Register.
• Adviser Led Secondary Transactions Rule – Requires RIAs to (i) obtain a fairness opinion or a valuation opinion when offering existing fund investors the option between selling their interests in a private fund or converting or exchanging their interests in another vehicle advised by the adviser or its related persons and (ii) provide a written summary of any material business relationships between the adviser and its related persons and the independent opinion provider.
  
  • No Legacy Treatment
  • Compliance Date
    
    • 12 months after publication – advisers with $1.5 billion or more of assets under management 
    • 18 months after publication – advisers with $1.5 billion or less of assets under management
• Amendment to the Annual Review and Recordkeeping Rule – Requires RIAs to annually review and document in writing the effectiveness of their compliance policies and procedures.
  
  • No Legacy Treatment
  • Compliance Date – The new annual review requirement begins sixty (60) days after publication of the Final Rules in the Federal Register.
  • Applies to all RIAs (including those who do not advise private funds).

Rules Applying to All Private Fund Advisers

• Restricted Activities Rule – All private fund advisers are restricted from certain activities unless the adviser obtains investor consent in some cases or in other cases discloses the activity to investors.
  
  • Consent Requirement
    
    • Fees for Investigations – Must obtain consent to charge or allocate expenses associated with an investigation of the adviser and the consent must be for a specific investigation with disclosure given of the amount of fees. If an investigation results in a sanction, charging the expenses is prohibited (notwithstanding the prior consent).
    • Borrowing from Private Fund Client – Advisers cannot borrow from a private fund client without disclosing such borrowing to all investors and receiving consent from the investors for each instance of the borrowing. Advisers must distribute a written notice and a description of the material terms of the borrowing.
  • Disclosure Requirement
    
    • Compliance or Regulatory Expenses – Advisers must disclose all fees and expenses that are charged or allocated to the funds for regulatory, examination or compliance fees and expenses of the adviser.
    • Reducing Clawback – If an adviser intends to reduce the clawback by an amount of taxes paid, the adviser must disclose the pre-tax and post-tax amount of the clawback.
    • Non-Pro Rata Allocation – Advisers cannot charge or allocate the fees and expenses related to a portfolio investment on a non-pro rata basis unless the allocation is fair and equitable under the circumstances and investors receive advance written notice of the non-pro rata charge and a description of how the approach is fair and equitable.
• Preferential Treatment Rule – The Final Rules prohibit all advisers from granting preferential terms for investors in a private fund or a Similar Pool of Assets (as defined below) under the following circumstances:
  
  • Preferential Redemptions – Advisers cannot offer preferential terms to an investor for redemption from the fund unless: (a) the terms are required by law; or (b) the preferential terms are offered to all investors in the private fund or a Similar Pool of Assets without qualification.
  • Access to Information – Advisers cannot offer preferential access to information on the fund or the fund’s investments unless the access is offered to all investors in the private fund or a Similar Pool of Assets.
  • Disclosure of Preferential Treatment – The Final Rules also require advisers to disclose any preferential treatment with respect to any “material economic terms” to all investors. The disclosure must be made: (a) to all investors after the first closing of the fund in case on an Illiquid Fund; (b) after an investor complete their investment in a Liquid Fund; and (c) on an annual basis to update on any new preferential treatment given in the previous year for both categories of funds.
• Legacy Treatment – Legacy treatment is allowed for the redemption and information consent requirements if the private fund commenced operations prior to the effective date of the Final Rules and if compliance with the Final Rules would require amending any existing documents. 
  
  • No legacy treatment for the disclosure requirements.
• Compliance Date – Eighteen (18) months from the publication of the Final Rules.

Rules Applying to Only RIAs

Quarterly Statements

The new rule 211(h)(1)-2 (the “Quarterly Statement Rule”) requires the distribution of quarterly statements to investors that contain detailed information regarding the compensation, fees, expenses, and performance of the funds. The quarterly statements must be delivered within forty-five (45) days after the end of the fund’s first three quarters and within ninety (90) days after the fund’s fiscal year ends. If such private fund is a fund of funds, then the quarterly statements must be delivered within seventy-five (75) days after the end of the fund’s first three quarters and within one hundred and twenty (120) days after the fund’s fiscal year ends. The Quarterly Statements Rule requires three standardized reports – a “fund table,” a “portfolio investment table,” and a “performance disclosure” including the following information:

Fund Table

• The quarterly statements must include a “fund table” that contains the line-item fund level information. The table is intended to provide investors with comprehensive fund fee and expense disclosure for the prior quarterly period. The table must include:
  
  • Detailed accounting for all compensation, fees, and other amounts allocated or paid to the RIA or any of its related persons by the private fund.
  • Detailed account of all fees and expenses otherwise allocated to or paid by the private fund that are not included above.
  • The amount of any offsets, rebates or waivers carried forward during the reporting period to subsequent quarterly period to reduce future payments or allocations to the RIA or its related persons.
• The Quarterly Statement Rule prohibits grouping smaller expenses into broad categories and, therefore, requires all expenses to be identified (with no de minimis expenses allowed to be excluded or un-categorized). This is a significant level of detail that will likely require most RIAs and private funds to materially increase the amount of reporting in their quarterly reports. 

Portfolio Investment Table

• The reports must include any compensation paid to the RIA by a portfolio investment. 
  
  • “Portfolio investment” is defined as any entity or issuer in which the private fund has invested directly or indirectly. This would include any entity or issuer in which the private fund holds an investment, including through any subsidiaries or special purpose vehicles and any other vehicles through which investments are made or otherwise held by the private fund. Investments made by private funds could capture more than just the single investment, such as if the private fund invests directly in a holding company that owns two subsidiaries, the definition would include all three entities.
  • A portfolio investment is covered if it paid the RIA or any related persons compensation during the reporting period. This means there must be separate line items for each category of allocation or payment reflecting the total dollar amount, including but not limited to, origination, management, consulting, monitoring, servicing, transaction, administrative, advisory, closing, disposition, directors, trustees, or similar fees or payments by the covered portfolio investment to the RIA or any of its related persons.

Performance Disclosure 

• The quarterly statements must include standardized and specific fund performance information. The disclosure requirements are different for Illiquid Funds and Liquid Funds.
• Liquid Funds must show the following performance information:
  
  • Annual net returns since inception or the last 10 fiscal years, whichever is shorter;
  • Average annual net total return over a one, five, and 10-year fiscal period; and
  • Cumulative net total return for the current fiscal year as of the end of the most recent fiscal quarter covered by the statement.
• Illiquid Funds must show:
  
  • Gross and net internal rate of return (“IRR”) and multiple of invested capital (“MOIC”) for the full fund since inception.
  • Separate gross IRR and gross MOIC for the realized and unrealized portions of the fund’s investments.
  • Statement of contributions and distributions for the fund, including all capital inflows and outflows and the net asset value of the fund as of the end of the reporting period.
  • The IRR must be calculated to the day of the report and cannot be calculated as of the middle of a quarter or month or another point in time chosen by the RIA.
• The performance metrics must be included both with and without the impact of any fund-level subscription facilities. Fund sponsors should now include both levered and unlevered performance figures and both sets of performance metrics in the quarterly reports.
• RIAs should also disclose any tax or other investor specific expenses that have or have not been deducted from returns.
• Disclosures and Cross References – The quarterly statements must also include the following information:
  
  • Prominent disclosure (in proximity to the required disclosure) regarding how all expenses, payments, allocations, rebates waivers and offsets are calculated. 
  • Cross references to the relevant sections of the fund documents, including a limited partnership agreement and a private placement memorandum, with the calculation methodology.
• Information included in the quarterly statements that is provided but is not required by the Final Rules to be included in the reports is subject to the marketing rules recently amended by the SEC³. Specifically, if the quarterly statements are made available to prospective investors, RIAs should treat the quarterly statement disclosures with the same care as any marketing material.

Application of Quarterly Statement Rule

• Applies to only RIAs.
• No Legacy Treatment – The quarterly reports must be provided for all new and existing funds after the compliance date of the Final Rules.
• Compliance Date – The Quarterly Reporting Rule will go into effect eighteen (18) months after publication of the Final Rules in the Federal Register.

Audit Rule

Rule 206(4)-10 (the “Audit Rule”) requires obtaining an annual audit of each private fund directly or indirectly advised by the RIA. The audits must meet the audit requirements of the Custody Rule. The Audit Rule includes the following:

• Audited financials be delivered to investors within one hundred and twenty (120) days of the fund’s fiscal year end.
• The Final Rules effectively eliminate the use of surprise examination exemption under the Custody Rule for RIAs.⁴
• Financial statements must be prepared in accordance with GAAP or other substantially similar accounting standards.
• There is one limited exception to RIA’s obligations: if the RIA does not control or is not in common control with the fund that it advises, the RIA is only required to take “all reasonable steps” to cause the fund it advises to meet the Audit Rule.

Application of the Audit Rule

• Applies to only RIAs
• No Legacy Treatment – Audits must be provided for all new and existing funds after the compliance date of the Final Rules.
• Compliance Date – The Audit Rule will go into effect eighteen (18) months from the publication of the Final Rules in the Federal Register.

Adviser-Led Secondary Transactions

Rule 211(h)(2)-2 (the “Adviser Led Secondaries Rule”) requires RIAs to satisfy certain requirements if they initiate a transaction that offers fund investors the option between selling all or a portion of their interests in the private fund and converting or exchanging them for new interests in another vehicle advised by the RIA or any of its related persons. These transactions are deemed to be adviser-led secondary transactions. 

In the event of an adviser-led secondary transaction, the RIA must satisfy the following two requirements:

• First, the RIA must obtain a fairness opinion or a valuation opinion from an independent opinion provider and distribute the opinion to investors prior to when investors must decide whether to consent.
• Second, the RIA must prepare and distribute a written summary of any material business relationships between the adviser or its related persons and the independent opinion provider.

The fairness or valuation opinion and the summary of any material business relationships must be distributed to private fund investors prior to the date the investors are required to make the election with regard to the transaction. RIAs must retain a copy of fairness opinion or valuation opinion and the material business relationship summary, as well as a record of each addressee to whom these materials were distributed and the date of distribution.

Application of the Adviser-Led Secondary Transaction Rule

• Applies to only RIAs
• No Legacy Treatment
• Compliance Date
  
  • 12 months after publication – advisers with $1.5 billion or more of assets under management 
  • 18 months after publication – advisers with $1.5 billion or less of assets under management

Amendment to the Annual Review and Recordkeeping Rule

The Final Rules require that all RIAs must at least annually review the adequacy of their compliance policies and procedures and the effectiveness of their implementation and, importantly, to document this review in writing.

Application of Review and Recordkeeping Rule

• Applies only to RIAs (including those who do not advise private funds)
• No Legacy Treatment
• Compliance Date – Because it is an amendment to an existing rule, the new annual review requirement begins sixty (60) days after publication of the Final Rules in the Federal Register.

Rules Applying to All Private Fund Advisers

Restricted Activities Rule

The new rule 211(h)(1)-2 (the “Restricted Activities Rule”) creates categories of restricted activities that either require prior written consent from investors or that require disclosure to investors. 

Consent

• Consent means the fund advisers must obtain prior written consent from at least a majority in interest of investors who are not related persons to the adviser.
  
  • The Final Rules allow the fund documents to generally govern the methods of giving consent. Advisers should be cautious with the use of negative consent procedures for these items that require consent as the SEC generally prefers affirmative consent when consent is required by law or rule.
  • The SEC is also likely to question the use of Limited Partner Advisory Committees or other fund governance bodies for providing consent. The SEC is increasingly viewing those bodies as conflicted and often does not deem their consent sufficient.
• Fees for Investigations – Consent is required to charge or allocate to a fund the fees or expenses associated with a government or regulatory investigation of the adviser or its related person. 
  
  • Blanket or upfront consents will not be sufficient.
  • The disclosure must include the specific fees and expenses that are expected to be incurred for each investigation. The fees and expenses should each be included as a separate line item in the disclosure.
  • There is a complete prohibition on advisers charging any fees or expenses relating to an investigation that results in a court or governmental authority imposing a sanction for violating the Advisers Act or any of its rules. 
  • If any fees were consented to, the adviser must fully refund the fees if the investigation concludes with a sanction. 
• Borrowing from a Private Fund Client – Consent is required for advisers to directly or indirectly borrow money, securities, or other fund assets, or receive a loan or extension of credit, from a private fund client.
  
  • Advisers must also distribute a notice to each investor of the material terms of the borrowing, loan, or extension of credit (e.g., the amount of money to be borrowed, the interest rate, and the repayment schedule).
  • Investors must receive notice of the material terms of each individual borrowing, which means a blanket, up-front consent may not be sufficient.
  • The Final Rules do not prevent advisers from borrowing from a third party on the fund’s behalf or prevent advisers from lending to the fund.

Notice

• For some activities, the Final Rules require particular types of notice rather than consent from investors. The activities are still allowed without consent, but investors must be notified as required in the Final Rules.
• Compliance or Regulatory Fees – Advisers can charge or allocate to a fund any regulatory or compliance fees or expenses associated with an examination, but the adviser must provide the investors with notice of such fees or expenses, including the dollar amount of such fees or expenses, within forty-five (45) days of the end of the quarter in which the charges occur.
• Reduced Clawback – If an adviser intends to reduce the clawback by actual, potential, or hypothetical taxes then the adviser must distribute notice to the investors of the aggregate dollar amounts of the before and after-tax amounts of the clawback. The notice must be sent within forty-five (45) days after the end of the quarter when the clawback occurred.
• Non-Pro Rata Allocation – Advisers are prohibited from charging or allocating fees and expenses related to a portfolio investment or potential portfolio investment on a non-pro rata basis without meeting the requirements of the Final Rules.
  
  • Such non-pro rata allocation or charge approach must be fair and equitable.
  • Prior to the charge or allocation, the adviser must distribute an advance written notice to each investor of the non-pro rata charge or allocation and a description of how the allocation approach is fair and equitable under the circumstances.

Application of Notice and Consent

• Applies to all private fund advisers
• No Legacy Treatment
  
  • Consent – Legacy treatment applies to the requirements for consent if compliance with the Final Rules would require an amendment to the existing fund documents.
  • Notice – There is no legacy treatment for the notice requirement and all advisers must comply.
• Compliance Date 
  
  • 12 months after publication – advisers with $1.5 billion or more of assets under management 
  • 18 months after publication – advisers with $1.5 billion or less of assets under management

Preferential Treatment Rule

Rule 211(h)(2)-3 of the Final Rules (the “Preferential Treatment Rule”) changes the rules for how advisers are able to negotiate different rights and privileges for investors in the funds. Advisers are not strictly prohibited from some activities and must disclose other types of preferential treatment. These rules apply to all private fund advisers.

• Prohibited Preferential Redemptions – The Final Rules explicitly prohibit giving investors in private funds or a Similar Pool of Assets the ability to redeem its interests on terms the adviser would reasonably expect to have a material, negative impact on other investors in that private fund or a Similar Pool of Assets.
  
  • The limited exceptions include if the ability to redeem is required by law.
  • Advisers may also offer a special ability to redeem if that ability was offered to all existing investors and the adviser offers the same ability to any new investors in the private fund or a Similar Pool of Assets.
  • The Final Rules also prohibit different share classes with different liquidity terms if those share classes are offered based on the size of investment.
• Prohibited Preferential Access to Information – Advisers cannot provide information regarding portfolio investments to any investor if the adviser reasonably believes providing such information would have a material, negative effect on other advisers.
  
  • Similar to redemptions, preferential access can be offered if the same information is offered to all existing investors.
  • The Final Rules include all types of communications between the adviser and investors and almost any information communicated to investors (i.e., this prohibition is not limited to side letters).

Preferential Treatment

• The Final Rules do not prohibit preferential treatment of particular investors. This was a positive development from the Proposal which may have almost eliminated the ability of an adviser to use side letters. However, the Final Rules do include new and onerous disclosure requirements of any preferential treatment of investors.
• All types preferential treatment to any investors in a private fund must be disclosed under the following requirements:
  
  • Before a prospective investor invests in the fund, the adviser must provide an advance written disclosure regarding the preferential treatment of any “material economic terms” previously offered to all other investors in the same fund. 
    
    • “Material economic terms” is included, but not limited to, the cost of investing, liquidity rights, fee breaks, and co-investment rights. Material economic terms could include additional items and advisers should generally include disclosure of anything relating to treating one investor preferentially to another investor.
  • As soon as reasonably practicable (i) after the end of the fundraising period in an Illiquid Fund; and (ii) after the investor completes their investment in a Liquid Fund, the adviser must provide additional post-closing written disclosure of all preferential treatment to any investors.
  • Advisers must annually provide an updated written notice to investors notifying them of any preferential treatment provided since the last written notice.

Similar Pool of Assets

• As noted above, the Preferential Treatment Rule (and disclosure requirements associated with the Rule) applies with regard to not only the investors in each fund but also with respect to investors in any Similar Pool of Assets. “Similar Pool of Assets” is defined as any a pooled investment vehicle (other than an investment company registered under the Investment Company Act of 1940 or a company that elects to be regulated as such) with substantially similar investment policies, objectives, or strategies to those of the private fund managed by the adviser or its related persons.
• Parallel funds and co-investment funds may be captured under the foregoing definition. For example, an adviser’s healthcare-focused private fund may be considered a Similar Pool of Assets to the adviser’s technology-focused private fund under the definition.
• Whether a pool of assets managed by the adviser is “similar” to the private fund requires a facts and circumstances analysis. A pool of assets with a materially different target return or sector focus, for example, would likely not have substantially similar investment policies, objectives, or strategies to those of the subject private fund, depending on the facts and circumstances.

Application of the Preferential Treatment Rule

• All private fund advisers must comply with the Preferential Treatment Rule and document compliance with the disclosure and consent requirements as applicable (including a copy of communication distributed and/or received).
• Legacy Treatment
  
  • Legacy treatment is allowed for the redemption and information consent requirements if the private fund commenced operations prior to the effective date of the Final Rules and if compliance with the Final Rules would require amending any existing documents. 
  • The disclosure requirements allow for no legacy treatment and thus all private fund advisers will be required to disclose side letters, including those agreed to prior to the Final Rules, upon eighteen (18) months from the publication of the Final Rules.

^{1 Unless otherwise indicated, the Compliance Date applies the same regardless of assets under management. In the specific instances indicated herein, assets under management may affect the Compliance Date.}

^{2 17 CFR § 275.206(4)-2 (the “Custody Rule”) requires that an RIA with custody of client funds or securities establish a set of controls and safeguards for those client assets. The Custody Rule requires the fund assets are maintained with a qualified custodian and must either (1) undergo surprise examinations by an independent public account or (2) undergo annual audits of the funds. The Final Rules do not include the surprise examination exemption permitted under the Custody Rule. While RIAs could still use the surprise examinations to comply with the Custody Rule, they must obtain the annual audits to comply with the Final Rules notwithstanding any such surprise examinations. Investment adviser should seek specific advice and counsel regarding compliance with the Custody Rule.}

^{3 Advisers Act Rule 206(4)-1 (Marketing Rule)}

^{4 Rule 206(4)-2(a)(4) of the Advisers Act requires an RIA with custody of client assets to obtain an annual surprise examination by an independent public account, but the surprise examination is not required if the fund is subject to an annual audit by a registered public account and distributes the audited financial statements within 120 days of the end of the fiscal year. As noted above, the Final Rules do not allow for the surprise examination and require the annual audit.}