SEC Adopts New Rules for Private Fund Advisers

Earlier this week (August 23, 2023), the Securities and Exchange Commission (SEC) adopted rules that will dramatically expand the compliance and operational obligations of private fund advisers when they come into effect on the dates mentioned below. As SEC Chairman Gary Gensler explained, these new rules, which include amendments to certain existing rules under the Investment Advisers Act of 1940 (Advisers Act) and are collectively referred to as the “Private Fund Advisers Rule,” are intended to enhance “advisers’ transparency and integrity, [and] help promote greater competition and thereby efficiency.” The new requirements under the Private Fund Advisers Rule are summarized below.

Restricted Activities Rule. All private fund advisers (regardless of whether (a) registered or required to be registered with the SEC (RIAs) or (b) unregistered and exempt from registration (Unregistered Exempt Advisers)) will be prohibited from:

• Charging or allocating to a private fund fees or expenses associated with a governmental or regulatory authority investigation of the adviser that results in sanctions for violations under the Advisers Act
• Without prior investor consent, charging or allocating to a private fund fees or expenses associated with any governmental or regulatory authority investigation of the adviser or borrowing money or receiving an extension of credit from a private fund
• Without prior notice to investors, charging or allocating to a private fund any fees or expenses of an adviser and its clients (including its private fund clients) related to a portfolio investment among such clients on a non-pro rata basis
• Charging or allocating to a private fund any regulatory, examination, or compliance fees or expenses of the adviser, unless the adviser notifies the investors in such private fund of any such fees or expenses, and the dollar amount thereof, within 45 days after the end of the fiscal quarter in which the charge occurs
• Reducing an adviser clawback by applicable taxes, in each case, unless the adviser notifies the investors in such private fund of the aggregate and tax adjusted clawback amounts within 45 days of the quarter end in which the clawback occurs

Preferential Treatment Rule. All advisers to private funds (regardless of whether RIAs or Unregistered Exempt Advisers) will be prohibited from:

• Granting preferential redemption rights to an investor that are not otherwise required by law and that the adviser reasonably expects or should expect have a material, negative impact on the other investors in the private fund, unless the adviser offers such redemption rights to all investors without qualification
• Selectively providing information regarding the portfolio holdings or exposures of a fund to an investor where the adviser reasonably expects or should expect that the disclosure of such information to an investor would have a material, negative impact on other investors in the fund, unless the adviser offers such information to all investors at substantially the same time
• Directly or indirectly providing any other preferential treatment to an investor, unless the adviser notifies current and prospective investors in the fund of such preferential treatment. Material economic concessions must be disclosed to prospective investors before they are admitted to a private fund; other side letter concessions must be disclosed promptly after the final closing of an illiquid fund or, for liquid funds, promptly after the admission of such investor.

The Preferential Treatment Rule grandfathers funds that have provided preferential redemption or information rights to certain investors prior to the compliance date of the Private Fund Advisers Rule, and advisers will not be required to provide the same rights to all the other investors in any such legacy fund. Preferential treatment afforded by such funds, however, must be disclosed to the other investors in such funds. The legacy (grandfathering) provisions will apply only with respect to advisers’ existing agreements with parties as of the compliance date.

Quarterly Statement Rule. Private fund RIAs will be required to provide quarterly reporting to investors regarding fund-level performance information, the cost of investing in the fund, fees and expenses paid by the fund, and compensation and fees paid to the adviser. These reporting requirements distinguish between liquid and illiquid funds and establish different standards for each type of fund.

Private Fund Audit Rule. Private fund RIAs will be required to cause each fund that they advise to undergo a financial statement audit that meets the requirements of the Custody Rule. The SEC simultaneously reopened comment on the proposed rule regarding the safekeeping of advisory client assets (the Safeguarding Rule), which had closed on May 8, 2023, through the date 60 days after publication in the Federal Register of the Safeguarding Rule comment period re-opening notice.

Adviser-Led Secondaries Rule. Adviser-led secondary transactions are defined as transactions initiated by the adviser or any of its related persons that offer the private fund’s investors the choice between selling their interests in that private fund and converting or exchanging their interests in the private fund for interests in another vehicle advised by the adviser or any of its related persons. In contrast to the proposal, the final rule excludes tender offers from the scope of adviser-led secondary transactions. In connection with any adviser-led secondary transaction, private fund RIAs will be required to obtain and distribute to investors a fairness or valuation opinion from an independent opinion provider, along with a summary of any material business relationships the adviser has, or has had within the prior two years, with the independent opinion provider.

New Record Keeping Requirements. The SEC added new recordkeeping requirements relating to the Quarterly Statement Rule and the Private Fund Audit Rule to the Books and Records Rule. In addition, the SEC amended the Advisers Act Compliance Rule to require that all RIAs make and preserve written documentation of their annual internal compliance reviews, which the SEC may inspect upon request.

Importantly, securitized asset funds are excluded from the term “private funds,” and the SEC states that the Quarterly Statement Rule, Private Fund Audit Rule, Adviser-Led Secondaries Rule, Restricted Activities Rule, and Preferential Treatment Rule will not apply to investment advisers with respect to their advised CLOs, CDOs, CBOs, and other structured products that issue asset-backed securities and primarily issue debt to their investors.

Compliance Dates.

• Private Fund Audit Rule and Quarterly Statement Rule: 18 months after publication in the Federal Register, meaning no earlier than February 24, 2025.
• Adviser-Led Secondaries Rule, Preferential Treatment Rule, and Restricted Activity Rule:
  • Advisers with US$1.5 billion or more in AUM attributable to private funds: 12 months after publication in the Federal Register, meaning no earlier than August 24, 2024.
  • Advisers with less than US$1.5 billion in AUM attributable to private fund assets: 18 months after publication in the Federal Register, meaning no earlier than February 24, 2025.
• Compliance Rule Amendment: 60 days after publication in the Federal Register, meaning no earlier than October 24, 2023.

In addition to dramatically modifying and expanding the compliance obligations of private fund advisers, the Private Fund Adviser Rule has the potential to significantly impact certain investment terms that have historically been negotiated privately between advisers and investors.

We expect potential litigation challenging the Private Fund Advisers Rule before the rule comes into effect, and we will continue to monitor the legal landscape. Should it survive legal challenges and go into effect, with past being prologue, advisers’ compliance with the Private Fund Adviser Rule is likely to be a focus of future examination activity by the SEC’s Division of Examinations and investigative sweeps by the SEC’s Division of Enforcement.¹

We are carefully reviewing the SEC’s adopting release for the Private Fund Advisers Rule (which differs from the proposing release in certain key areas) and will publish a more in-depth review of the new rule in the near future.

© Arnold & Porter Kaye Scholer LLP 2023 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.