Whether everyday Americans saving for retirement, college tuition, or their forever homes know it or not, there’s a chance that their money is tied, directly or indirectly, to private funds. Moreover, those Americans probably don’t consider themselves investors in private funds and likely view private fund investors as ultra-high net worth individuals and institutional investors. But as a result of how pension plans, college and university endowment funds, banks, and financial institutions, in connection with their private fund advisers, invest their own money, everyday Americans are, in effect, tied to the relationship between private funds and private fund advisers. But how does information flow between the advisers and the fund, and thereafter to investors? What do the fees and expenses look like in connection with that investment, and how are these fees calculated? How is private fund performance calculated, and how does such calculation affect an investment, and, as a result, the fees being exchanged between the adviser and the fund? And relatedly, does this opaque flow of information create any conflict of interest between the adviser and the private fund on the one hand and the investor on the other?
On February 9, 2022, the Securities and Exchange Commission (the “SEC”) proposed both new and amended rules under the Investment Advisers Act of 1940 to address some of these information and transparency concerns that, if adopted, would impose new SEC and investor reporting requirements on certain private fund advisers (the “Proposed Rules”). While it is anticipated that the rulemaking staff remains actively evaluating public comments, many industry experts expect the Proposed Rules to become final this year. This article aims to provide a brief overview of four main components of the Proposed Rules and their perceived intent.
The Proposed Rules would require investment advisers to prepare a quarterly statement that includes certain information in respect of fees, expenses, and performance for any private fund that it advises and distribute these statements to the fund’s investors within 45 days following the end of each quarter. To be clear, these statements would be at the fund level, and are not required to be personalized for each investor, but rather a broader snapshot of the fund’s performance, fees, and costs. It’s intended that these statements likely provide better insight as to otherwise often-discretionary nature of how fees and expenses are incurred pursuant to a fund’s governing agreements (e.g., limited partnership agreement, limited liability company agreement, offering documents, etc.).
The SEC believes these reports would improve the quality of information provided to fund investors, allowing them to assess and compare their investments, ensure the fund’s compliance with its governing agreements and disclosures, and better understand the fees and expenses the investor bears. On the latter point in particular, while the transparency on fees and expenses may assist an investor’s understanding of the performance of the fund and how money is being used, it may also provide insight as to how the adviser benefits from such fees and expenses. The ultimate goal appears to be a check on fund adviser and fund management, allowing an investor to get a better picture of the fund’s operations.
In addition to the quarterly statements, the Proposed Rules require fund advisers providing investment advice, whether directly or indirectly, to obtain an annual audit of the financial statements of the funds they manage. The audit must be done by an independent public accountant and be done in accordance with accounting standards of independence and in accordance with GAAP. This requirement overlaps in part with the Custody Rule (a discussion of which is outside the scope of this article) and surprise examinations by accountants in lieu of obtaining an audit, but notably diverts from the option of a surprise examination under the Custody Rule; instead the fund must obtain the annual audit. Additionally, a fund adviser would be required to enter into an agreement with the auditor requiring the auditor to notify the SEC Division of Examinations upon the termination of the auditor or the issuance of a modified opinion.
The SEC believes this annual audit would provide meaningful protections to investors by increasing the likelihood that both valuation issues and fraudulent activities would be uncovered, thereby deterring the funds from acting fraudulently or overvaluing the fund. The deterrence against fraudulent activity is an obvious one — an annual, independent audit of a fund committing fraud, when viewed with the eye of a sophisticated investor, is likely to uncover such fraudulent activity. Prospective investors, however, are likely to use the audit to ensure the fund adviser is not overvaluing the fund’s performance to entice such investors. Moreover, the SEC believes that the audit may provide a check against adviser misrepresentations to investors in respect of fees and expenses, performance, and other information about the fund.
The Proposed Rules would also prohibit certain advisers from engaging in certain transactions entirely, representing a significant departure from the SEC’s current approach. These activities would be prohibited regardless of whether the fund’s governing documents allow it or even if the investors expressly consent to them. Such activities include (but are not limited to): (i) providing certain preferential treatment to some investors but not others, and, if providing preferential treatment that is not expressly prohibited, disclosing such treatment to other investors (e.g., disclosing side letter agreements), (ii) charging certain fees and expenses to, or borrowing money from, the fund, and (iii) seeking reimbursement, indemnification, exculpation, or limitation of its liability by the fund or the investors for a breach of fiduciary duty, bad faith, negligence, or recklessness. These prohibitions would apply to all advisers, regardless of whether they’re registered with the SEC.
The impetus behind the prohibitions is that the activities incentivize advisers to place their own interests ahead of their clients and the investors, creating inherently unfair deals and uneven playing fields. Side letters, for example, often grant preferential treatment to one (or a group of) investor(s), which may also benefit the adviser itself. Thus, providing the other (and prospective) investors with these side letter agreements makes transactions inherently fairer. Moreover, while an adviser may continue to limit its liability for breaches of fiduciary duties to a narrow set of claims under state law (e.g., Delaware), the SEC is taking the position that such an adviser may be held liable for a broader set of claims under federal law. In other words, the SEC is taking the approach that an adviser could be held liable for simple negligence in connection with the fund documents, making it easier for an investor to bring a claim against an adviser. As a result, the governing documents of many funds will likely need amending to comply with the Proposed Rules. Overall, these prohibitions aim to better align the advisers’ goals with those of the investors.
Finally, the Proposed Rules would require an adviser, prior to closing an adviser-led secondary transaction, to distribute both: (i) a fairness opinion from an independent opinion provider; and (ii) a summary of any material business relationships the adviser (or any of its related persons) has with the independent opinion provider. The Proposed Rules provide insight on what the SEC understands to be an adviser-led secondary transaction for the sake of the Proposed Rules: when the adviser facilitates, and importantly initiates, a transaction whereby an investor (i) may sell interests in the fund to a third party or (ii) converts their interests in the fund to that of another vehicle.
The SEC believes that when an adviser initiates transactions like those described above, certain conflicts are created. For example, an adviser may have an undisclosed economic benefit in respect of the deal, such as additional management fees or carried interest. This ultimately may lead to the adviser determining the terms of the deal while inherently conflicted. The fairness opinion would ensure the terms of the transaction are fair and reasonable to the investor, while the material business relationships disclosure would show an investor whether the opinion provider and the adviser have a pre-existing relationship that would create further conflict.
The Proposed Rules are aimed at better aligning the interests of advisers and investors by mitigating conflicts of interest and providing more information to investors. While some of the proposals, such as annual audits and quarterly reports, may already be common practice, the Proposed Rules seek to mandate these practices. That said, with liability limitations (e.g., lowering the bar on liability limitations to simple negligence), required disclosures (e.g., the disclosure of preferential side letter agreements), and the prohibition on certain activities altogether (e.g., preferential liquidity terms), each represent a material and significant change.
On the one hand, the material departures from past practices that open the door for investors to bring more lawsuits against funds and their advisers — i.e., suing for simple negligence — has venture capital firms and private equity funds concerned, and representatives in the industry have submitted comments regarding the same. Moreover, the liability threshold being shifted downward (therefore making it easier for an investor to bring a claim) is likely to increase the amount of diligence advisers have to undergo to ensure they’re protected from these claims. On the other hand, an environment where information flows more freely (as a result of both the increased diligence and the advisers’ and funds’ concern as to liability limitation) and investors have better insight into the funds may lead to more investing which is, of course, a net positive for the funds and the advisers. Regardless of the actual effect as to the perceived intent, the Proposed Rules, if finalized, will bring substantive changes in the world of private funds, for their advisers and investors alike.
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 Section 202(a)(29) of the Investment Advisers Act of 1940 defines the term “private fund” as an issuer that would be an investment company, as defined in Section 3 of the Investment Company Act of 1940 (15 U.S.C. 80a-3) (“Investment Company Act”), but for Section 3(c)(1) or Section 3(c)(7) of that Act.