On August 23, 2023, the U.S. Securities and Exchange Commission (“SEC”) adopted new rules under the Investment Advisers Act of 1940 (“Advisers Act”) applicable to both SEC-registered and unregistered private fund advisers (“Rules”). Among other requirements, the Rules require registered private fund advisers to provide investors with quarterly statements and yearly audited financial statements. In addition, the Rules place restrictions on the ability of both registered and unregistered private fund advisers to give preferential treatment to certain investors. Below is a summary of the provisions under the Rules that we consider to be the most noteworthy.
Quarterly Statement and Audit Requirements
The Rules require registered private fund advisers to present investors with quarterly statements detailing the fund’s performance, fees, expenses and any other compensation paid to the adviser (or its related persons) by the fund or the fund’s portfolio companies. While the current SEC custody rules require registered investment advisers with custody of client assets to provide quarterly account statements to clients, private fund advisers are exempt from this requirement if they distribute annual audited financial statements to fund investors. Although it’s customary for private funds to provide at least quarterly reports to investors, registered private fund advisers should nonetheless confirm that their current reporting procedures comply with the Rules. The SEC will require compliance with the quarterly statement provision within 18 months after the Rules become effective.
Under the current SEC custody rules, registered private fund advisers are generally required to either distribute audited financial statements to investors or be subject to an annual surprise examination. The Rules effectively eliminate the surprise examination option and require all registered advisers of private funds to distribute audited financial statements to investors at the end of each fiscal year. Despite the available options under the custody rule, private funds typically elect to distribute audited statements to investors; as such, we do not expect the annual audit requirement under the Rules to impact the current practices of most registered private fund advisers. Like the quarterly statement rule, the SEC will require compliance within 18 months after the Rules become effective.
The Rules prohibit both registered and unregistered private fund advisers from providing certain preferential treatment to investors regarding redemption and information rights. Further, the Rules require additional disclosures when funds provide other preferential terms to investors. These provisions will significantly affect an adviser’s ability to enter into side letter agreements with investors.
In the case of redemptions, advisers will no longer be permitted to provide preferential redemption rights to certain investors that the adviser reasonably expects to have a material, negative effect on other investors. As an example, the SEC discussed how allowing an investor to redeem early may leave a fund with fewer liquid assets to use when satisfying future redemption requests for other investors.
The Rules provide for two exceptions to the preferential redemption rights prohibition: (i) redemptions required by applicable laws (i.e., if needed to comply with pay-to-play laws) and (ii) preferential redemption rights afforded to all current and future investors. For example, a fund is still permitted to have separate share classes with different redemption rights provided that each share class is available to all investors. However, the separate share classes must be available without qualification and not contingent on investment amount, affiliation to the adviser, etc.
Additionally, the Rules prohibit private fund advisers from providing preferential information rights regarding portfolio holdings or exposures to certain investors if the adviser reasonably expects such preferential treatment to have a material, negative effect on the other investors. According to the SEC, selective disclosure of portfolio holdings could allow certain investors to profit or avoid losses at the expense of other investors without access to such additional information. The SEC also pointed to issues in funds with preferential redemption rights where investors could withdraw capital and “front-run” the fund.
Finally, the Rules require private fund advisers to disclose other types of preferential treatment arrangements to current and potential investors. Specifically, advisers must disclose all preferential treatment related to any material economic terms prior to an investor’s investment. Advisers must also provide investors with annual disclosures of all other preferential treatment arrangements provided to investors since the prior notice. The first notice must be provided (i) for a closed-end fund, as soon as reasonably practicable following the end of the fund’s fundraising period; and (ii) for an open-end fund, as soon as reasonably practicable following the investor’s investment in the fund.
Managers with $1.5 billion or more in private fund assets under management are required to comply with the preferential treatment rule within 12 months of the effective date. All other advisers are required to comply with the rule within 18 months of the effective date. Notably, the preferential treatment prohibitions will not be applied retroactively to governing agreements that were in effect prior to the compliance date and would need to be amended to comply with the Rules. In contrast, no such “legacy status” will be granted with respect to the preferential treatment disclosure requirements under the Rules.
Overall, we believe the preferential treatment portions of the Rules are the headliner. Side letters with preferential terms for certain investors are a longstanding hallmark of operating and investing in private funds—eliminating much of the practice will recalibrate the power dynamics between fund sponsors and certain investors and likely have far-reaching effects upon the entire industry. In the near term, advisers with existing preferential terms in place will need to work with legal counsel to ensure they comply with the new disclosure requirements under the Rules. We will be closely monitoring how the private fund industry adapts to the Rules over the coming months. Please feel free to reach out to us should you have any questions.
 The Rules will become effective within 60 days of publication in the federal register.