The Securities and Exchange Commission (“SEC”) announced on February 9, 2022, proposed rules and amendments (“Proposed Rules”) under the Investment Advisers Act of 1940 that would impose significant new requirements and prohibitions on investment advisers to hedge funds, private equity funds and other Investment Company Act Section 3(c)(1) or 3(c)(7) private funds, as well as increase compliance obligations with respect to all registered advisers. With the scope of the Proposed Rules impacting SEC and state registered fund advisers along with exempt reporting advisers and other private fund advisers that are not subject to reporting or registration requirements, all investment advisers should monitor the Proposed Rules closely. If adopted in present form, the Proposed Rules will considerably impact an investment adviser’s compliance obligations and conduct in the following areas.
For SEC-registered private fund advisers, the Proposed Rules would require the following new obligations:
Quarterly Statements
Advisers registered or required to be registered with the SEC would be required to prepare and distribute quarterly statements disclosing standardized information on fund performance, fees and expenses, including compensation paid by a private fund’s portfolio investments to the adviser or any of its related persons. The quarterly statements would be required to be distributed to investors within 45 days after the end of each calendar quarter.
Annual Private Fund Audits
Advisers registered or required to be registered with the SEC would be required to obtain an audit of the financial statements of each private fund it manages at least annually, as well as upon liquidation. The audits would generally be required to be conducted in accordance with U.S. GAAP by an independent public accountant that meets the independence standards of Regulation S-X and is registered with the PCAOB. The audited financial statements would be required to be distributed to investors promptly after the audit is completed.
Fairness Opinion for Adviser-Led Secondaries.
In the context of an adviser or any of its related persons soliciting and offering existing fund investors the option to sell, convert or exchange 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, the Proposed Rules would require SEC-registered fund advisers to obtain and distribute to investors a fairness opinion prior to closing the transaction, opining as to the fairness of the price being offered to the private fund for any assets being sold as part of the transaction. The Proposed Rules would require that the fairness opinion be provided by an independent opinion provider that provides such opinions in the ordinary course of business, and the adviser would be required to disclose certain material relationships between the adviser and the opinion provider.
For all private fund advisers, including those that are not registered or required to be registered with the SEC, or are exempt reporting advisers or unregistered advisers, the Proposed Rules would prohibit such advisers from engaging in certain activities, as described below. (We note that this approach taken in the Proposed Rules appears to conflict with the SEC’s fiduciary duty interpretation, which allows for certain conflicts of interest to be averted through full disclosures.)
Prohibited Activities
- Charging certain fees to a private fund or its portfolio investments, such as fees for unperformed services (e.g., accelerated monitoring fees) and fees associated with an examination or investigation of the adviser.
- Seeking reimbursement, indemnification, exculpation or limitation of its liability for adviser misconduct, including ordinary negligence.
- Reducing the amount of clawback of carried interest for an adviser or its related persons by the amount of certain taxes.
- Allocating fees or expenses related to portfolio investments, in circumstances where multiple private funds and other clients advised by the adviser or its related persons have invested in the same portfolio investment, on a non-pro rata basis.
- Borrowing from private fund clients.
- Providing preferential treatment to certain investors related to (i) redemption or other liquidity rights or (ii) information about portfolio holdings or exposures, if such terms would have a material, negative effect on the other investors in the fund or substantially similar pool of assets.
- Providing other preferential treatment to certain investors unless such treatment is disclosed in writing to all current and prospective investors by either describing the preferential treatment in sufficient detail or by providing copies of investor side letters. Advisers would be required to deliver these disclosures before an investor makes an investment in the fund, and annually thereafter.
All SEC-registered advisers, regardless of whether they are private fund advisers, would further be required by the Proposed Rules:
- To prepare and retain a written report and documentation of the currently required annual review of compliance policies and procedures.
- To retain records relating to these new disclosure requirements, including records evidencing calculation methods for all expenses, fees, payments, allocations, rebates, offsets, waiver and performance metrics disclosed to investors.
If adopted in their current form, the Proposed Rules would require advisers to modify their practices and terms of their existing private funds no later than one year from the effective date of each new and amended rule. The public comment period on the Proposed Rules will remain open until April 25, 2022. The text of the Proposed Rules may be found here: https://www.sec.gov/rules/proposed/2022/ia-5955.pdf
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