Key Points:
The SEC proposes to require registered private fund advisers to provide investors with quarterly statements regarding select information, detailing requirements such as:
Fund advisers would be prohibited from seeking reimbursement, exculpation, indemnification, limitation of liability for specific activities
Charging some fees/ expenses to private funds or portfolio investments
Reducing the amount of adviser clawback by tax amount
Charging fees and expenses relevant to portfolio investments on a non-pro rata basis
Borrowing/ receiving extensions of credit from private fund client
The Advisers Act compliance rule would be amended to require all registered advisers to document an annual review of compliance policies and procedures in writing
The rule was designed with the goal of increasing transparency, efficiency, and competition in the private-equity market
What’s Happening and Why it Matters
In February 2022, the Securities and Exchange Commission (SEC) voted in favor of new rules and amendments under the Investment Advisers Act of 1940 (Advisers Act) to enhance the regulation of private fund advisers and to protect private fund investors by increasing transparency, competition, and efficiency in the $18-trillion marketplace.
Some of these proposed rules would greatly expand regulatory compliance obligations for all investment advisers to private funds such as exempt reporting advisers, foreign private advisers, and other investment advisers to private funds that are not otherwise required to register with the SEC.
Said SEC Chair Gary Gensler: “’Private fund advisers, through the funds they manage, touch so much of our economy. Thus, it’s worth asking whether we can promote more efficiency, competition, and transparency in this field. I support this proposal because, if adopted, it would help investors in private funds on the one hand, and companies raising capital from these funds on the other.’"
But what does this all really mean? The proposed rules were intended to increase transparency by requiring registered private fund advisers to provide investors with quarterly statements including information on fund fees, performance, and expenses.
In addition, the proposed rules would stop private fund advisers, even those not registered with the SEC, from giving preferential treatment to investors in their funds, as well as all other preferential treatment unless disclosed to current and prospective investors.
The proposed changes would also include new requirements for private fund advisers as related to fund audits, books, and records, plus adviser-led secondary transactions.
The new proposals would also prevent all private fund advisers from engaging in specific activities such as reimbursement, indemnification, exculpation, or limitation of liability for particular activities, charging fees and expenses to a private fund or its portfolio investments, including fees for unperformed services and fees associated with investigations or examinations of advisers.
It would also include the reduction of the amount of adviser clawback by the amount of certain taxes; charging fees or expenses related to a portfolio investment on a non-pro rata basis, as well as borrowing or receiving an extension of credit from private fund clients.
Another rule included in the proposed amendments is a compliance one that requires all registered advisers, such as those that do not advise private funds, to document annual reviews of compliance policies and procedures in writing.
Furthermore, the Proposed Rules would prevent private fund advisers from entering into an agreement with an investor to provide any other kind of preferential treatment without also providing:
Written notice to each prospective investor that includes specific disclosure regarding the preferential treatment.
An annual written notice to current investors in an ongoing offering that includes specific disclosure regarding any preferential treatment provided by the private fund adviser to other investors in the private fund.
Private fund advisers will also be able to comply with disclosure requirements if they provide copies of side letters (with identifying information on investors redacted) or by providing a detailed summary of preferential terms provided.
More Details
Quarterly Statements
There will be a principles-based approach to quarterly reporting with fund-level disclosures as a minimum standard. The proposed distribution requirement will be 45-days post quarter close.
Fee and Expense Disclosure
The SEC’s objective is an apples-to-apples comparison of costs particularly to avoid categorizing costs as “other.”
Performance Disclosure
Performance metrics will be disclosed “without” the impact of fund-level subscription facilities, and there will be a move to a standardized methodology on performance disclosures over time.
Mandatory Private Fund Adviser Audits
There will be a mandatory annual audit.
Adviser-Led Secondaries
Advisers will be required to obtain fair opinions in connection with adviser-led secondary transactions wherein advisers offer investors the option to sell their interests in the private fund or to exchange them for new interests in another vehicle advised by the adviser.
Prohibited Activities
Fees for Unperformed Services
GPs will not be able to charge a fund or portfolio investment for unperformed services.
Certain Fees and Expenses
All compliance costs associated with the adviser’s operation of the fund will be the responsibility of the adviser or manager, with all compliance costs being disclosed and transparent to LPs.
Reducing Adviser Clawbacks for Taxes
Advisers will be prohibited from reducing the amount of any clawback by any actual, potential, or hypothetical tax rate, with the intention of making interests align between LPs and GPs.
Limiting or Eliminating Liability for Adviser Misconduct
The SEC is attempting to rein in problematic but mainstream practices in fund documentation that shifts the risk burden to fund LPs, which in turn reduces standards of care and loyalty.
Certain Non-Pro Rata Fee and Expense Allocations
Advisers will not be allowed to charge certain fees and expenses to a private fund or portfolio investment such as accelerated monitoring fees, fees, or expenses associated with an examination or investigation of the adviser or related persons by governmental or regulatory authorities, and more.
Borrowing
Advisers or related persons will not be allowed to borrow from the fund.
Preferential Treatment
Prohibition on Preferential Redemption Rights
The SEC will prohibit preferential and early redemption rights of investors to encourage fairness among all investors involved. It will create a universal minimum requirement for portfolio level disclosures for institutions subject to public records act requirements.
Disclosure of Any Preferential Treatment
Advisers registered with the Commission would need to retain books and records to support their compliance with the preferential treatment rule. Advisers would also be required to retain copies of all written notices that were sent to investors in a private fund.
Industry Reactions
Side letters:
From www.klgates.com: “This aspect of the Proposed Rules represents a significant departure from the current practice of many private fund advisers and institutional and other investors with respect to side letters and other similar written agreements. Rather than a privately negotiated side letter process, private fund advisers would be required to provide all investors and prospective investors with specific information regarding preferential terms of side letters, adding a new dynamic to the already complex negotiation of key terms.”
“Preferential treatment”:
From www.aima.org: “In an attempt to significantly curtail side letter arrangements, the Preferential Treatment Rule would prohibit all private fund advisers from providing any preferential treatment to certain investors regarding redemption or preferential transparency rights or portfolio holdings or exposures information. Other preferential treatment may only be afforded to investors if the adviser provides written disclosures of such preferential treatment to prospective and current investors. If adopted as proposed, the Preferential Treatment Rule would require that an adviser describe specifically the preferential treatment in order to convey its relevance to other investors. For example, an adviser would need to specifically describe favorable fee arrangements given to certain investor(s) rather than merely disclosing that some investors pay lower fees than others.”
From www.klgates.com: “The SEC has not provided guidance as to what constitutes “preferential treatment” or “specific” information of such preferential treatment, leaving private fund advisers to determine the level of information to be included in notices to prospective and current investors. This lack of clarity may lead to challenging judgment calls when assessing whether, for instance, noneconomic side letter terms constitute preferential treatment.”
Seeding Arrangements:
From www.klgates.com: “Many smaller and emerging managers forge relationships with one or a handful of “seed” or “anchor” investors, who provide outsized capital commitments and contributions of time and expertise to help a manager establish itself in the market. In return, such seed investors are typically given favorable terms with respect to fund-level investments. While the Proposed Rules would require disclosure of such terms, the distinctive active role that seed investors play would distinguish their arrangements from those of other investors making a “passive” fund investment.”
Allowances for regulatory requirements:
From www.klgates.com: "Notably absent from the Proposed Rules is an exception allowing for common liquidity terms and restrictions on receipt of confidential information that are related to the regulatory status of certain types of investors, such as the Employee Retirement Income Security Act of 1974 and governmental plans. Inflexibility in this area may have the effect of limiting the universe of investment opportunities for certain classes of investors.”
Addressing potential misconduct:
From www.managedfunds.org: “[W]e believe that re-proposed Rule 9j-1 will deter market participants from entering into security-based swap transactions that are necessary or appropriate for their hedging or other portfolio objectives in order to avoid potentially exposing themselves to liability merely for performance of their contractual obligations.“
Examinations and Enforcement Actions:
From www.axios.com: “The American Investment Council, which represents dozens of big PE firms, signaled strong concerns with what it views as "unnecessary" rules. Law firm Simpson Thacher, which represents lots of PE funds, called the proposals "intrusive" and said they "assume a bleak view" of fund manager behavior.”
From www.mayerbrown.com: “This portion of the Proposal could be subject to a strict liability standard. Given the Proposal’s specific requirements with respect to content and formatting, some expect the SEC could be on the lookout for technical violations of the reporting requirements if they are adopted”
Potential CLO Impact:
From www.mayerbrown.com: “Some CLOs use side letters between certain investors, and the CLO collateral manager and these letter letters can include a sharing or rebating of a portion of such manager’s management fees. The letters are usually not shared with other investors, and to do so would eliminate or “chill” this customary market practice. The effect of this requirement could be substantial and could make affected investments more expensive (to maintain the economics) or lose such investments altogether, reducing capital formation.”
Comment Letters from Others
“Colmore is in favor of all proposals put forward by the Commission in sections II.A.1 (“Fee and Expense Disclosure”), II.A.2 (“Performance Disclosure”), and II.A.3 (“Preparation and Distribution of Quarterly Statements”) of the Release and they address many of the concerns raised by our LP clients. However, we feel that some of the proposals could be expanded in scope to provide investors with further clarity around the performance of the fund and the investor-specific fees being charged.”
Full response here.
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Read the full SEC proposal here.
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