US Securities and Exchange Commission (SEC) Chairman Gary Gensler has ramped up an aggressive regulatory agenda that zeroes in on advisers to private funds. On February 9, 2022, the SEC commissioners approved several proposed rules under the Investment Advisers Act of 1940 (the Proposed Rules) which, if passed, would have significant effects on the operation of private funds. The Proposed Rules will include new requirements for investor quarterly statements, private fund audits, adviser-led secondaries, side letter practices and annual reviews, and the outright prohibition of certain activities. Several of the Proposed Rules will also apply to investment advisers not registered with the SEC, including venture capital fund advisers, smaller private fund advisers and many non-US advisers.
Below is a summary of the significant changes under the Proposed Rules. Comments to the Proposed Rules are due on the later of (a) 30 days after the Proposing Release is published in the Federal Register or (b) April 11, 2022.
Under the Proposed Rules, advisers to private fund managers (including SEC-registered and unregistered advisers) would be subject to the following:
Carried interest or incentive fee clawback requirements cannot be reduced by tax distributions;
Advisers cannot seek reimbursement, indemnification, exculpation or limitation of liability by the private fund or its investors for a breach of fiduciary duty, willful misfeasance, bad faith, negligence or recklessness in providing services to the private fund;
Advisers cannot charge private funds for certain accelerated monitoring fees and similar unearned fees and regulatory and compliance expenses of the adviser (including for SEC examinations and investigations);
Advisers cannot borrow from a private fund; and
Advisers cannot charge or allocate fees and expenses related to a portfolio investment (or potential portfolio investment) on a non-pro rata basis among multiple private funds and other clients.
Some of prohibited activities appear to be items the SEC and its staff have highlighted in past OCIE risk alerts, while others represent a significant departure from negotiated market terms in the private fund industry.
PREFERENTIAL TREATMENT: SIDE LETTER PRACTICE
SEC-registered and unregistered advisers, if providing preferential treatment for certain investors through side letters or otherwise, would be required to:
Disclose to investors prior to investing in a private fund any preferential treatment the adviser provides to any other investor; and
Annually provide disclosure of such treatment to all investors.
Advisers to private funds would be prohibited from providing preferential terms to certain investors in connection with fund withdrawals/redemptions and current portfolio/investment holding information if the adviser reasonably expects that providing the information would have a material, negative effect on other investors.
The Proposed Rules would require SEC-registered investment advisers to prepare a quarterly statement that includes certain information regarding fees, expenses and performance for any private fund that it advises; advisers would have to distribute the quarterly statement to the private fund’s investors within 45 days after the end of each calendar quarter. While most private funds may already follow quarterly reporting practices, the Proposed Rules would require the report to be presented in a specific manner, such as requiring:
A fee and expense table which includes:
Compensation, fees and other amounts allocated or paid to the adviser or any of its related persons by the private fund during the reporting period (e.g., management, advisory, sub-advisory, or similar fees or payments, and performance-based compensation);
All fund fees and expenses paid by the private fund during the reporting period (e.g., organizational, accounting, legal, administration, audit, tax, due diligence and travel expenses); and
The amount of any offsets or rebates carried forward during the reporting period to subsequent quarterly periods to reduce future payments or allocations to the adviser or its related persons.
A table with detailed accounting of all compensation allocated or paid to the adviser or its related persons by each portfolio company, including origination, management, consulting, monitoring, servicing, transaction, administrative, advisory, closing, disposition, directors, trustees, or similar fees or payments.
Specific performance information and metrics, which are different for liquid and illiquid private funds.
REQUIRED FAIRNESS OPINIONS FOR SPONSOR-LED SECONDARY TRANSACTIONS
Under the Proposed Rules, any sponsor/adviser-led secondary transaction of private fund interests would require an SEC-registered adviser to obtain a fairness opinion from a third-party firm. The adviser must also prepare and distribute to the private fund investors a summary of any material business relationships the independent opinion provider has or has had within the past two years with the adviser or any of its related persons.
REQUIRED PRIVATE AUDITS AND SEC REPORTING BY AUDITOR
Although most private funds distribute audited financial statements to investors pursuant to Rule 206(4)-2 under the Advisers Act (the custody rule), the Proposed Rules would mandate that all private funds managed by SEC-registered advisers be subject to a financial statement audit. More importantly, the auditor would be required to notify the SEC promptly upon the auditor’s termination or issuance of a modified opinion.
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