US SEC adopts wide-reaching rules for private fund advisers

On August 23, 2023, the Securities and Exchange Commission (SEC) adopted highly controversial new rules and rule amendments to the Investment Advisers Act of 1940 (the Advisers Act) in an effort to further regulate the private funds industry. These new rules attempt to "increas[e] transparency, competition and efficiency in the private funds market."

Important requirements of the new rules include the following:

For registered private fund advisers

Registered private fund advisers will now be required to:

1. distribute a quarterly statement to private fund investors that include the fund-level information regarding performance, the cost of investing in the private fund, fees and expenses paid by the private fund and amounts paid to the adviser (the Quarterly Statement Rule);
2. cause the private funds they manage to undergo a financial statement audit that meets the requirements of the audit provision in the Advisers Act's custody rule (the Private Fund Audit Rule);
3. obtain a fairness opinion or a valuation opinion when offering existing fund investors the option between selling their interests in a private fund and converting or exchanging their interests for interests in another vehicle advised by the adviser or any of its related persons; the adviser must distribute a summary of any material business relationships the adviser has, or has had within the prior two years, with the independent opinion provider, with the fund's investors (the Adviser-Led Secondaries Rule); and
4. facilitate the SEC's ability to assess an adviser's compliance with the rules through amendments to the books and records rule under the Advisers Act (the Books and Records Rule Amendments).

For all private fund advisers

All private fund advisers, including those not registered with the SEC, are now restricted from engaging in activities that are contrary to the public interest and the protection of investors without full disclosure and, in some instances, investor consent (the Restricted Activities Rule). This includes charging or allocating any fees or expenses to the private fund without the prior disclosure to fund investors for:

• regulatory, examination or compliance fees or expenses of the adviser;
• reducing the amount of an adviser clawback by the amount of certain taxes, without disclosing the pre-tax and post-tax amount of the clawback; and
• fees or expenses related to a portfolio investment on a non-pro rata basis, unless the allocation approach is fair and equitable and the adviser distributes advance written notice of the non-pro rata charge and a description of how the allocation approach is fair and equitable under the circumstances.

It also includes charging or allocating any fees or expenses to the private fund without the prior disclosure and consent of fund investors for:

• an investigation of the adviser, including, but not limited to, an investigation that results or has resulted in a court or governmental authority imposing a sanction for a violation of the Advisers Act; and
• borrowing or receiving an extension of credit from a private fund client.

Further, the reforms prohibit all private fund advisers from providing preferential treatment to certain investors for (i) certain redemptions from the fund (unless required by law) and (ii) certain preferential reporting regarding the investor's portfolio, unless such terms are offered to all investors. More broadly, all private fund advisers are prohibited from providing any preferential treatment to investors, unless certain terms are disclosed in advance of an investor's investment in the private fund and all terms are disclosed after the investor's investment (the Preferential Treatment Rule).

For all registered advisers

All registered advisers, including those that do not advise private funds, must document in writing, the required annual review of their compliance policies and procedures to allow for the SEC to determine advisers' compliance with the new rules and identify potential compliance weaknesses (the Compliance Rule Amendments).

Timelines and legacy status

The implementation of each new rule is subject to different timelines and certain legacy status. For governing agreements entered into prior to the compliance date that would require amendments to the current agreements, they are afforded legacy status with respect to the prohibitions aspect of the Preferential Treatment Rule and the investor consent requirements of the Restricted Activities Rule. Investment advisers that advise securitized asset funds are exempt from the Quarterly Statement Rule, Private Fund Audit Rule, Adviser-Led Secondaries Rule, Restricted Activities Rule and Preferential Treatment Rule for such funds.

The compliance dates are as follows:

• Private Fund Audit Rule and Quarterly Statement Rule: 18 months after publication in the Federal Register
• Adviser-Led Secondaries Rule, Preferential Treatment Rule and Restricted Activities Rule:
  • For advisers with at least US$1.5bn in private funds assets under management, 12 months after publication in the Federal Register
  • For advisers with less than US$1.5bn in private funds assets under management, 18 months after publication in the Federal Register
• Compliance Rule Amendments: 60 days after publication in the Federal Register

Conclusion

These new rules, first proposed in February 2022, will result in rigorous and likely burdensome compliance requirements and costs to thousands of US private funds and advisers, as well as certain foreign advisers who take money from US investors. We expect, at a minimum, that the SEC's statutory authority to enact these Rules concerning currently unregistered advisers will face multiple challenges in federal courts. In the meantime, private fund advisers should ensure they understand the scope and requirements of the new rules as widespread changes are expected to private fund advisers' side letter processes, investor communications, reporting and expense allocations, among other things.