On February 9, 2022, the Securities and Exchange Commission (the “SEC”) issued a proposal to enhance disclosure by, and address certain practices of, private fund advisers under the Investment Advisers Act of 1940 (the “Advisers Act”) (the “Proposed Rules”). The Proposed Rules, summarized below, are aimed at protecting private fund investors “by increasing visibility into certain practices, establishing requirements to address certain practices that have the potential to lead to investor harm, and prohibiting adviser activity that [the SEC] believe[s] is contrary to the public interest and the protection of investors.” The Proposed Rules would apply to registered advisers and, with respect to certain of the proposed changes, unregistered advisers.

Quarterly Reporting Requirements

Currently, private fund advisers are not subject to investor reporting requirements under the Advisers Act. In an effort to provide more transparency with respect to fees and expenses charged to private fund investors, as well as fund performance, the Proposed Rules would require registered advisers to provide (or cause a third party to provide) quarterly statements to their private fund investors within forty-five (45) days after each calendar quarter, detailing the following:

• Fund-Level Reporting: A detailed accounting of all 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 (“adviser compensation”); all fees and expenses paid by the private fund during the reporting period other than adviser compensation; 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.
• Investment-Level Reporting: A detailed accounting of all portfolio investment compensation allocated or paid by each covered portfolio investment during the reporting period, and the private fund’s ownership percentage of each such covered portfolio investment as of the end of the reporting period (or, if the percentage is zero, a brief description of the applicable investment).
• Performance Reporting: For liquid funds (e.g., hedge funds), standardized fund performance information based on net total return on an annual basis since the fund’s inception, over prescribed time periods, and on a quarterly basis for the current year (e.g., average annual net total returns over the one-, five-, and ten- calendar year periods, and the cumulative net total return for the current calendar year as of the end of the most recent calendar quarter covered by the quarterly statement). For illiquid funds (e.g., typical buyout or venture capital funds), standardized fund performance information based on the internal rate of return and a multiple of invested capital (e.g., gross and net IRR and MOIC, in each case computed without accounting for the impact of fund-level credit facilities). If adopted, advisers would also be required to present certain performance information with equal prominence.

Consolidated reporting would be required for substantially similar pools of assets to the extent doing so would provide more meaningful information to the private fund’s investors and would not be misleading. In addition, Rule 204-2 (the “books and records rule”) under the Advisers Act would be amended to require advisers to retain books and records related to the proposed quarterly statement rules, including records evidencing the calculation method for all expenses, payments and allocations and documentation substantiating the adviser’s determination that a client is a liquid fund or an illiquid fund.

Prohibited Activities

The Proposed Rules would prohibit all advisers to private funds, whether or not registered or exempt or prohibited from registration, from engaging in certain activities that the SEC considers “contrary to the public interest and the protection of investors.” Specifically, the Proposed Rules would prohibit private fund advisers from engaging in the following activities:

• Fees for Unperformed Services: Charging a portfolio investment for monitoring, servicing, consulting, or other fees in respect of any services the investment adviser does not, or does not reasonably expect to, provide to the portfolio investment.
• Certain Fees and Expenses: Charging a private fund for fees or expenses associated with an examination or investigation of the adviser or its related persons by any governmental or regulatory authority, as well as regulatory and compliance fees and expenses of the adviser or its related persons.
• Reducing Adviser Clawbacks for Taxes: Reducing the amount of any adviser clawback (sometimes referred to as a “General Partner clawback”) by actual, potential, or hypothetical taxes applicable to the adviser, its related persons, or their respective owners or interest holders.
• Limiting or Eliminating Liability for Adviser Misconduct: Directly or indirectly seeking reimbursement, indemnification, exculpation, or limitation of the adviser’s 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.
• Certain Non-Pro Rata Fee and Expense Allocations: Directly or indirectly charging or allocating fees and expenses related to a portfolio investment (or potential portfolio investment) on a non-pro rata basis when multiple private funds and other clients advised by the adviser or its related persons have invested (or propose to invest) in the same portfolio investment.
• Borrowing: Directly or indirectly borrowing money, securities, or other fund assets, or receiving a loan or an extension of credit, from a private fund client.

Current regulation generally permits these activities provided that the adviser discloses them to investors prior to subscription. The proposing release acknowledges that these prohibitions would present a change to existing market practices. Accordingly, if adopted, the Proposed Rules may require certain advisers to reevaluate pricing and expense allocation models and to update their legal documents to ensure compliance with the new requirements.

Mandatory Audits

The Proposed Rules would require private fund advisers to obtain annual, independent audits of each of their private funds’ financial statements. If adopted, audited financial statements will need to be prepared in accordance with GAAP, and the independent auditor engaged by an adviser must be engaged by a written agreement pursuant to which the auditor is required to notify the SEC upon the issuance of a modified opinion or the resignation or dismissal from, or other termination of, the audit engagement. The proposed mandatory audit requirements are based on the audit requirements under Rule 206(4)-2 under the Advisers Act (the “custody rule”), but unlike the custody rule, which allows an adviser to obtain a surprise examination by an independent auditor in lieu of obtaining an audit, the Proposed Rules do not offer an alternative to compliance, save for limited exceptions (e.g., if an adviser otherwise takes all reasonable steps to cause the audit).

Adviser-Led Secondaries

In connection with certain adviser-led secondary transactions (sometimes referred to as “GP-led secondaries”) where an adviser offers fund investors the option to sell their interests in a fund (or exchange their interests for interests in a continuation vehicle advised by the adviser), the Proposed Rules will require advisers to distribute a fairness opinion from an independent opinion provider to investors prior to closing of the transaction, along with a summary of any material business relationships the adviser or its related persons have, or have had within the two years prior, with the independent opinion provider.

Preferential Rights

The Proposed Rules would also limit an adviser’s ability to grant preferential rights to some but not all investors in a private fund, including rights that may be granted to investors in “side letters” or similar agreements with such investors that have the effect of establishing rights under, or altering or supplementing the terms of, a private fund’s governing documents. In particular, advisers would be prohibited from granting preferential redemption rights with respect to an investor’s interest in a fund or preferential information rights with respect to a fund’s underlying investments, in each case, if the adviser reasonably expects such preferential treatment would have a material, negative effect on other investors in the private fund or in a substantially similar pool of assets. Other preferential rights would also be prohibited, unless the adviser provides adequate disclosure to all investors regarding the preferential rights given to other investors in the same private fund.

Annual Review of Compliance Programs

The Proposed Rules would require registered investment advisers to document, in writing, the annual review of their compliance policies and procedures required under Rule 206(4)-7. Such documentation would enable the SEC staff to determine if the adviser has complied with this rule.

The Proposed Rules, together with other regulatory changes recently proposed by the SEC, including proposed amendments to Form PF reporting requirements for certain private fund managers and cybersecurity risk management rules for investment advisers and registered investment companies, would impose significant new regulatory requirements on the private fund industry. Comments on the Proposed Rules are due 30 days after publication in the Federal Register or April 11, 2022, whichever is later.

For additional information related to anything contained in this Client Alert, please contact Margaret D. Farrell, James R. Burke, Carlin O’Donnell, or any member of our Securities Law Practice Group.