New SEC private fund adviser rules expected tomorrow. A recap

On 9 February 2022, the SEC proposed new rules under the Investment Advisers Act of 1940.

If the final rules substantially follow the sweeping changes contained in the proposals, they would have significant implications for both the advisers themselves and the investors in the funds they advise.

We are expecting the final rules to be published by the SEC tomorrow (Wednesday 23 August).

We will report when these are available and will be following up with further analysis, including a Hedge Fund Vista call, in due course.

In the meantime, a high level reminder of the key areas that the proposals covered:

A. Registered private fund advisers only

The SEC's proposals would require registered private fund advisers to

• provide transparency to their investors through quarterly statements detailing information about private fund performance, fees, and expenses and
• obtain an annual audit for each private fund they advise
• distribute to investors a fairness opinion and written summary of certain material business relationships between the adviser and the provider of the opinion in connection with an adviser-led secondary transaction.

B. All private fund advisers

In addition, under the proposals, all private fund advisers (whether or not SEC registered and including U.S. and non-U.S. exempt reporting advisers) would be prohibited from

• engaging in certain sales practices, conflicts of interest and compensation schemes that are contrary to investor protection
• providing preferential treatment to certain investors in a private fund, unless the adviser discloses such treatment to other current and prospective investors.

C. Registered investment advisers (including those that do not advise private funds)

All registered investment advisers would be required to document in writing their annual review of the adequacy of the policies and procedures established under the compliance program rule and how effective their implementation is.

Looking at each of these in turn:

Quarterly Statement Rule

The proposal is designed to allow investors to better assess, monitor and compare their private fund investments.

Registered private fund advisers would be required to distribute a quarterly statement to private fund investors containing

• a detailed accounting of all fees and expenses paid by the private fund during the reporting period
• information regarding compensation or other amounts paid by the private fund’s portfolio investments to the adviser or any of its related persons
• information regarding the private fund’s performance.

For liquid funds, the statement would provide

• annual net total returns since inception
• average annual net total returns over prescribed time periods and
• quarterly net total returns for the current calendar year.

For illiquid funds, the statement would provide

• the gross and net internal rate of return and
• gross and net multiple of invested capital
  to capture performance from the fund’s inception through the end of the current calendar quarter.

Private Fund Audit Rule

Under the proposed new rules, registered private fund advisers would be required to obtain a financial statement audit for each private fund they advise and to do so at least annually and on the fund’s liquidation.

These audited statements would need to be distributed to investors promptly after their completion.

Adviser-Led Secondaries Rule

Registered private fund advisers would be required to obtain a fairness opinion in connection with an adviser-led secondary transaction.

Where an adviser offers fund investors the option of exchanging their interests in one private fund for interests in another fund advised by the same adviser, an independent opinion provider would give a view on the fairness of the price being offered.

The adviser would also be required to prepare and distribute to investors a summary of any material business relationships the independent opinion provider has with the adviser (or any related person) or has had within the past two years.

Prohibited Activities Rule

The proposal would prohibit all private fund advisers from engaging in certain practices. This would help address conflicts of interest that, in the SEC’s words, “incentivize an adviser to place its interests ahead of the private fund’s interests” and so could lead to fraud and/or investor harm.

The practices targeted include:

• charging certain fees and expenses to a private fund or its portfolio investments.
  These would include fees for unperformed services (e.g., accelerated monitoring fees) and fees associated with the adviser being examined or investigated by a governmental or regulatory authority
• seeking reimbursement of any regulatory or compliance fees or expenses of the adviser or a related person
• reducing the amount of an adviser clawback by taxes (actual, potential or hypothetical) applicable to the adviser
• seeking reimbursement, indemnification or limitation of its liability for a breach of fiduciary duty in providing services to the private fund
• charging fees or expenses related to a portfolio investment on a non-pro rata basis where more than one private fund and other clients which the adviser advises have invested (or propose to invest) in the same portfolio investment and
• borrowing or receiving an extension of credit from a private fund client.

Preferential Treatment Rule

This proposal is intended to protect investors by prohibiting all private fund advisers from providing specific types of preferential treatment regarding redemptions from the fund or information about portfolio holdings or exposures that would have a material and negative effect on other investors.

It also would prohibit all private fund advisers from providing other preferential treatment unless disclosed to current and prospective investors

Written Documentation of Compliance Program Annual Reviews

Finally, the SEC is proposing to amend an existing rule to require all registered investment advisers to document their annual review in writing.

The proposal specifies no reporting elements that must be included in the written documentation but recites the relevant part of the Investment Company Act, which requires, among other things, an annual compliance report to a registered fund’s board of directors, including

• the operation of the registered fund’s compliance policies and procedures (and of each of the registered fund’s investment advisers)
• any material changes made to those policies and procedures since the date of the last report and
• each material compliance matter that occurred since the date of the last report.