Private Fund Adviser Rules

On August 23, 2023, the U.S. Securities and Exchange Commission (the “SEC”) adopted new rules aimed primarily at advisers to private funds (the “Private Fund Adviser Rules” or “PFA Rules”). The PFA Rules place significant new restrictions on certain practices and impose significant new disclosure and reporting obligations on advisers to private funds.  The private funds industry took significant issue with the PFA Rules prior to their adoption and industry trade groups have already filed a petition in the United States Court of Appeals for the Fifth Circuit seeking review of the PFA Rules, arguing that the SEC exceeded its authority in adopting them.

CERTAIN OF THE PFA RULES APPLY BROADLY TO BOTH REGISTERED AND UNREGISTERED ADVISERS

Virtually every manager that provides advisory services to private funds, regardless of whether the manager has registered with the SEC as an investment adviser (an “RIA”), will be impacted by the PFA Rules. The PFA Rules are a combination of five separate rules and one rule amendment that applies to all RIAs, even if the RIA does not advise private funds.   Some of the PFA Rules expressly apply to unregistered investment advisers (including Exempt Reporting Advisers (“ERAs”), state-registered investment advisers, foreign private advisers, and other non-registered investment advisers), as well as RIAs. Advisers to private funds can refer to the following chart to determine how the PFA Rules apply, given the adviser’s registration status. 
 

Rule	RIA	Unregistered
Restricted Activities	X	X
Preferential Treatment	X	X
Audit	X
Adviser-Led Secondaries	X
Quarterly Statements	X
Amendments to Compliance Rule	X

 

SUMMARY OF THE PFA RULES

RULES APPLICABLE TO ALL PRIVATE FUND ADVISERS

RESTRICTED ACTIVITIES RULE:  the Restricted Activities Rule prohibits private fund advisers from engaging in a number of specified activities without disclosure, and in some cases, investor consent.[1] 
 

INVESTIGATION  EXPENSES (Consent Required)	COMPLIANCE EXPENSES
Charging or allocating fees or expenses associated with a regulatory investigation of the adviser or related person, except with the advance written consent of a majority in interest of investors. Even with consent, the PFA Rules prohibit an adviser charging the expense of an investigation to a private fund if the investigation results in a sanction.	Charging regulatory or compliance costs and expenses of the adviser to the private fund without providing all fund investors written notice of the amount of these costs and expenses, within 45 days of the end of the fiscal quarter in which such expenses are incurred.
REDUCING CLAWBACK BY TAXES	NON-PRO RATA ALLOCATION OF PORTFOLIO COMPANY EXPENSES
Reducing the amount of a clawback payable by the adviser to a private fund by the amount paid by the adviser in taxes without providing written notice of the aggregate dollar amount of the clawback both before and after any such reduction, within 45 days of the end of the fiscal quarter in which such reduction occurs.	Allocating fees and expenses attributable to portfolio investments on a non-pro rata basis (between funds or clients) unless (i) such allocation is fair and equitable and (ii) the adviser distributes a written notice to investors prior to making such non-pro rata allocation.
BORROWING MONEY OR SECURITIES (Consent Required)
Borrowing money, securities or other assets from the private fund without first disclosing the material terms of the borrowing and obtaining advance written consent from a majority in interest of investors.

PREFERENTIAL TREATMENT RULE: the Preferential Treatment Rule prohibits private fund advisers from  granting preferential redemption or withdrawal rights or providing preferential information to any investor in a private fund or any similar pool of assets, without either offering or providing the same preferential treatment to all investors.  The Preferential Treatment Rule also requires private fund advisers to make certain additional periodic disclosures to existing and prospective investors relating to any preferential treatment provided to investors, including with respect to “material economic terms.”

RULES RELATING TO PREFERENTIAL LIQUIDITY AND TRANSPARENCY
 

PREFERENTIAL LIQUIDITY	PREFERENTIAL TRANSPARENCY
Granting an investor the right to redeem or withdraw its interest in a private fund or a similar pool of assets on preferential terms unless (i) required by applicable law or (ii) offered to all existing and future investors in the private fund or similar pool of assets.	Providing information regarding portfolio holdings or exposures of a private fund or a similar pool of assets unless provided to all other investors in the private fund and any similar pool of assets at the same or substantially the same time.

The Preferential Treatment Rules described above apply only when the adviser reasonably expects preferential liquidity or preferential transparency to have a “material, negative effect on other investors.”  This qualification, however, may have limited utility in practice. It is hard to imagine a scenario where preferential liquidity in either an open-end or closed-end fund, and portfolio transparency in an open-end fund, could not arguably have a material negative effect on other investors. While the provision of preferential information in a closed-end fund does not introduce the same conflicts of interests as with an open-end fund, the SEC did note that the adviser must consider the facts and circumstances relating to the disclosure of information and whether such disclosure could permit the preferred investor to front-run other investors in taking a short position against the applicable assets or potentially causing losses to other investors in the fund or similar pools of assets.

Finally, even if an adviser determines that the preferential treatment does not have a “material, negative effect on other investors”, the adviser will still be required to disclose such preferential treatment in the adviser’s annual preferential treatment disclosures discussed below.

DISCLOSURE OF PREFERENTIAL TREATMENT
 

DISCLOSURE REQUIREMENTS APPLICABLE TO PREFERENTIAL TREATMENT
PROSPECTIVE INVESTORS	UPON INVESTMENT
Prior to investment, all prospective investors must be provided with a written notice of all preferential treatment granted in the applicable private fund with respect to material economic terms, including preferential liquidity and transparency rights.  This notice must contain “specific information” and cannot simply state that some investors may be charged lower fees.	Written disclosure of all preferential treatment (that are not material economic terms) in the applicable private fund as soon as reasonably practicable following the end of the private fund’s fundraising period (in the case of closed-end funds), or as soon as reasonably practicable following an investor’s investment in the private fund (in the case of open-end funds).
ANNUALLY
Provide all current investors with “specific information” regarding any preferential treatment afforded by the adviser or its related persons since the last annual notice.

AGREEMENT NOT REQUIRED: The Preferential Treatment Rule simply requires that preferential information be “provided” to investors and does not require a written agreement or “side letter”.   Also, the rules relating to the provision of preferential information apply regardless of the mode of communication of information; which can be written, verbal, visual or other. A private fund adviser should be cautious when, in an effort to be responsive to an investor or in response to an RFP, provides such investor with performance estimates, details relating to current portfolio holdings, ESG matters, trading activity or fund exposures.  Such information, if not provided to all investors, at substantially the same time, may cause the adviser to violate the Preferential Treatment Rule.  Compliance professionals should review and approve any and all such requests, train investor relations personnel and monitor communications made to investors on a periodic basis.

“SIMILAR POOLS OF ASSETS”:  Private fund advisers should note that the Preferential Treatment Rule applies to both to the private fund as well as any “similar pool of assets”.   Under the rule, a “similar pool of assets” is any pooled investment vehicle with substantially similar investment policies, objectives, or strategies to those of the private fund managed by the private fund adviser or its related persons.  If the private fund adviser provides preferential transparency or liquidity rights to investors in any similar pool of assets, these rights must be offered to all existing investors in the private fund and any similar pool of assets at the same time or substantially the same time.  Certain parallel funds and co-investment vehicles may be considered a “similar pool of assets” and should be carefully considered when evaluating the impact of the Preferential Treatment Rule.

LEGACY STATUS: The PFA Rules provide for a limited “grandfathering” of preferential treatment terms for funds that have commenced operations and have entered into written agreements prior to the compliance date (see below).  The Legacy Status provided under the PFA Rules exempt private fund advisers from certain aspects of the Restricted Activities Rule that require investor consent (borrowing from a private fund or charging certain investigation fees) and certain of the restrictions and limitations under the Preferential Treatment Rule.  However, while the Legacy Status provisions effectively “grandfather” certain side letter agreements entered into prior to the compliance date, they do NOT relieve the adviser from its obligations to disclose preferential terms to current and potential investors in the private fund after the compliance date.

RULES APPLICABLE ONLY TO REGISTERED ADVISERS TO PRIVATE FUNDS

QUARTERLY STATEMENT RULE[2]:  the Quarterly Statement Rule requires RIAs to private funds to provide detailed performance, fee and expense information to all investors on a quarterly basis.  Notably, quarterly statements must also include prominent disclosure (contained in proximity to the required disclosure) relating to the manner in which all expenses, payments, allocations, rebates, waivers, and offsets are calculated AND must include cross references to the sections of the private fund’s organizational and offering documents that sets forth the applicable calculation methodology.

The quarterly statements produced and delivered by registered private fund advisers must include three standardized tables – a “fund table”, a “portfolio investment table” and a “performance table”. 
 

Fund table	Portfolio investment table
A detailed accounting of all compensation, fees, and other amounts paid to the adviser or any of its related persons. A detailed accounting of all fees and expenses allocated to or paid by the private fund. The amount of any offsets or rebates carried forward during the reporting period to subsequent periods to reduce future payments or allocations to the private fund adviser or its related persons. Information must presented both before and after the application of any offsets, rebates, or waivers.	A detailed accounting of all portfolio investment compensation allocated or paid to the private fund adviser or any of its related persons by any covered portfolio investment (including dollar amount, presented both before and after the application of any offsets, rebates, or waivers).
PERFORMANCE TABLE
The information required to be disclosed in the performance table depends upon whether a private fund is an illiquid fund or a liquid fund.  While some care must be taken in deciding whether to classify a private fund as “liquid” or illiquid” for purposes of the PFA Rules, generally speaking, open-end funds that allow for periodic redemptions or withdrawals are “liquid funds” and closed-end funds with no such redemption or withdrawal rights are “illiquid funds”. Liquid Funds:  (i) annual net total returns over the past 10 fiscal years or since inception; (ii) annual net total returns over one, five, and ten year periods; and (iii) cumulative net total return for the current fiscal year as of the end of the most recent fiscal quarter. Illiquid Funds: (i) gross IRR and gross MOIC;  (ii) net IRR and net MOIC;  (iii) gross IRR and gross MOIC for the realized and unrealized portions of the illiquid fund’s portfolio; and (iv) a statement of contributions and distributions for the illiquid fund.  All performance information for an Illiquid Fund must be computed with and without the impact of any fund-level subscription facilities.

AUDIT RULE:  the Audit Rule requires RIAs to private funds to obtain an annual financial statement audit (meeting the requirements of such an audit under the Custody Rule) for each private fund advised.  Advisers should note that while currently, a surprise examination satisfies an exemption under the Custody Rule for advisers to private funds, a surprise examination will NOT be sufficient for purposes of complying with the audit requirements under the PFA Rules. 

While most private funds are audited annually, advisers to SPVs and co-investment vehicles that rely upon surprise examinations should carefully consider the impact of this new Audit Rule.

ADVISER-LED SECONDARIES RULE:  the Adviser-Led Secondaries rule requires that RIAs, prior to the due date of an election form with respect to participation in the secondary transaction: (i) obtain and distribute to investors, a fairness opinion or valuation opinion from an independent opinion provider; and (ii) distribute a written summary of any material business relationships with the independent opinion provider.

Adviser led secondaries are commonly used when an adviser offers investors in an existing closed-end private fund the ability to “roll-over” their investment in a new private fund, effectively extending the life of the previous private fund.  However, the Adviser Led Secondaries Rule will apply any transaction initiated by the adviser (or any of its related persons) that offers private fund investors the choice between selling, converting or exchanging all or a portion of their interests in a private fund for interests in another vehicle advised by the adviser or any of its related persons.

AMENDMENT TO THE COMPLIANCE RULE APPLICABLE TO ALL REGISTERED ADVISERS

The PFA Rules include amendments to the Compliance Rule to require ALL SEC-registered investment advisers, including those that do not advise private funds, to document in writing the required annual review of their compliance policies and procedures. Because the Audit Rule will be effective within 60 days following publication, this amendment will impact most advisers with respect their current 2023 annual assessments.

COMPLIANCE DATES

The PFA Rules will become effective 60 days following their publication in the Federal Register (the “Effective Date”).  Following are the compliance dates (each a “Compliance Date”) for each of the PFA Rules which, in some cases, depend upon the level of private fund assets under management:
 

PFA RULE	COMPLIANCE DATE ($1.5B[3] in private fund assets or more)	COMPLIANCE DATE (less than $1.5B in private fund assets)
Compliance Rule Amendment	60 days	60 days
Restricted Activities Rule	12 months	18 months
Preferential Treatment Rule	12 months	18 months
Adviser Led Secondaries Rule	12 months	18 months
Audit Rule	18 months	18 months

 
NOTE ON SEC’s FIDUCIARY DUTY POSITION IN THE PFA RULES
The PFA Rules are substantially similar to the private fund adviser rules the SEC originally proposed in February 2022.  However, in response to critical comments from the private funds industry, the SEC made some significant changes to the proposal in the final PFA Rules. These concessions may ultimately be illusory for many advisers to private funds and therefore, not necessarily a “win” for the private funds industry.

For example, the final PFA Rules dropped the proposal’s prohibition on a private fund adviser seeking reimbursement, indemnification, and exculpation from liability resulting from the adviser’s simple negligence.  However, in the adopting release to the PFA Rules, the SEC stated that most of the activities for which an adviser might seek indemnity under a simple negligence standard were “already prohibited by the Federal fiduciary duty and antifraud provisions” applicable to investment advisers. The SEC has put the industry on notice that it would likely view any attempt by an adviser to seek indemnity for losses stemming from the adviser’s negligence as inconsistent with an adviser’s fiduciary duty, subjecting the adviser to potential SEC enforcement actions. 

Mark Strefling and David Fitzgerald, partners in Sadis’ Regulatory and Financial Services groups, have prepared this client alert summarizing the new rules promulgated recently by the SEC with respect to advisers to private funds.  Please do not hesitate to contact either of them or your primary contact at Sadis for questions regarding how to navigate this evolving regulatory landscape.