Key Takeaways:
- The Final Rules apply to both SEC-registered Investment Advisers (RIAs) and Exempt Reporting Advisers (ERAs) and will usher in significant changes in the regulation of private funds.
- RIAs will be required to: (1) provide statements to fund investors that disclose fees and expenses paid by such investors and detail the performance of such investments on a quarterly basis; (2) conduct an annual financial statements audit (if not already doing so) of each fund they advise; and (3) provide a valuation or fairness opinion along with certain disclosures regarding their relationship with the opinion provider prior to any advisor-led secondary transaction.
- All investment advisors including ERAs will be restricted from: (1) conducting certain activities without providing fund investors with disclosures or getting such investors’ written consent (as applicable); and (2) providing preferential treatment to certain investors in a private fund unless certain disclosure requirements are met.
Background:
The Securities and Exchange Commission (the “SEC”) adopted new rules and amendments to existing rules under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) with respect to the regulation of private fund advisers (the “Final Rules”). The SEC noted these rules and amendments were necessary to address: (i) a lack of transparency, (ii) conflicts of interest, and (iii) a lack of strong governance mechanisms at private funds.
While the Final Rules distinguish between RIAs and ERAs, the applicability of the Final Rules is not linked to the size of an investment adviser’s assets under management so all investment advisers will need to comply with some portion of the Final Rules depending on their RIA or ERA status. Luckily, the Final Rules grandfather in certain arrangements that private funds put in place prior to the compliance date, removing the need for fund managers to renegotiate existing agreements.
Do the Final Rules apply to all advisers?
Different portions of the Final Rules apply to different advisers depending on their registration and/or exemption status.
Applicable to RIAs only:
- Quarterly Statement Rule
- Audit Rule
- Adviser-Led Secondaries Rule
Applicable to all advisers to private funds (i.e., RIAs and ERAs):
- Restricted Activities Rule
- Preferential Treatment Rule
Quarterly Statement Rule
The Quarterly Statement Rule (Rule 211(h)(1)-2) mandates that RIAs must reveal two key aspects: (i) the fees and costs investors will incur, and (ii) the performance of those investments. Moreover, RIAs must disclose compensation received from the fund and its underlying portfolio investments.
For RIAs overseeing liquid funds (defined in the glossary), they need to display yearly performance using net total return for the shorter of the past 10 fiscal years or since the fund's inception. This performance should be presented over one-, five-, and ten-year periods, as well as cumulatively for the current fiscal year up to the latest quarter's end.
For RIAs managing illiquid funds (defined in the glossary), they must showcase performance using internal rates of return (IRR) and investment capital multiples since the fund's beginning. Additionally, they should provide a breakdown of contributions and distributions.
Quarterly statements must follow a consistent tabular format and be delivered within 45 days after each fiscal quarter's end. For the fiscal year-end, the deadline is extended to 90 days for regular funds and 120 days for funds of funds (defined in the glossary).
The Quarterly Statement Rule establishes a standardized performance metric for private funds. This can simplify performance comparison among similar funds and enable portfolio performance tracking in real-time for limited partners (LPs). However, this rule might be challenging for smaller General Partners (GPs) who may lack sufficient resources to comply effectively.
Compliance date: 18 months after publication in the Federal Register, meaning no earlier than February 24, 2025.
Mandatory Private Fund Adviser Audit Rule (“Audit Rule”)
The Audit Rule (i.e., Rule 206(4)-10) requires RIAs that are not already obtaining an audit under the IA Custody Rule (i.e., another SEC audit rule), with respect to a private fund that they directly or indirectly advise, to cause such private fund to undergo an annual financial statement audit that meets the following requirements:
- Must be performed by an independent public accountant subject to inspection by the PCAOB;
- Must meet a specific definition of audit;
- Audited financial statements must be prepared in accordance with GAAP; and
- Must provide annual financial statements within 120 days of the end of the fiscal year and promptly after a liquidation.
The Audit Rule is intended to protect funds and their investors against potential misappropriation of fund assets, and provide a check on both the RIA’s valuation of fund assets and potential conflicts of interest between the RIA and the fund investors. Opponents of the Audit Rule note that most firms already audit the funds they manage on an annual basis, so this rule is likely adding more cost without bringing much value to investors.
Compliance date: 18 months after publication in the Federal Register, meaning no earlier than February 24, 2025.
Adviser-Led Secondaries Rule
The Adviser-Led Secondaries Rule (Rule 211(h)(2)-2) mandates that RIAs involved in transactions where fund investors can choose to either (1) sell part or all of their interests in a private fund or (2) swap them for interests in another advised vehicle (known as adviser-led secondaries) must fulfill two new requirements.
First, the RIA must obtain a written opinion confirming that the offered price for the sold assets is reasonable (a “fairness opinion”) or that the assets' value is validated by an independent opinion provider (a “valuation opinion”). This opinion needs to be given to investors before they make a binding decision. Second, the RIA must disclose any connection between the investment adviser and the independent opinion provider in the two years prior to the opinion.
This rule emerges due to the rise in GP-led secondary transactions, which the SEC sees as having potential conflicts of interest. While this rule increases the cost and potentially reduces the appeal of such transactions for GPs, LPs gain more insight into conflicts of interest and more certainty about asset prices. Some critics question how beneficial these fairness and valuation opinions truly are for LPs and whether they genuinely enhance transparency in the secondary process.
Compliance date:
- Advisers with US$1.5 billion or more in AUM attributable to private funds: 12 months after publication in the Federal Register, meaning no earlier than August 24, 2024.
- Advisers with less than US$1.5 billion in AUM attributable to private fund assets: 18 months after publication in the Federal Register, meaning no earlier than February 24, 2025.
Restricted Activities Rule
The Restricted Activities Rule (i.e., Rule 211(h)(2)-1) requires adequate disclosure – and in some cases obtaining written consent – in order for an adviser to engage in certain activities.
**While the fund’s governing agreements can specify the manner and process for obtaining such consents, the consent of a limited partner advisory committee (LPAC) instead of the investors themselves is not permitted.
Compliance date:
- Advisers with US$1.5 billion or more in AUM attributable to private funds: 12 months after publication in the Federal Register, meaning no earlier than August 24, 2024.
- Advisers with less than US$1.5 billion in AUM attributable to private fund assets: 18 months after publication in the Federal Register, meaning no earlier than February 24, 2025.
Preferential Treatment Rule
The Preferential Treatment Rule (i.e., Rule 211(h)(2)-3) prohibits all investment advisers from:
- Granting a fund investor the ability to redeem its interest in a way that the adviser “reasonably expects” to have a material, negative effect on other fund investors unless required by law or offered to all current and future investors;
- Providing information regarding portfolio holdings or exposures of a private fund to any fund investor if the adviser “reasonably expects” that providing such information would have a material, negative effect on other investors in that fund unless the adviser offers such information to existing fund investors at substantially the same time; and
- Providing any other preferential treatment to any investor in the private fund unless the adviser delivers certain written notice of the material economic terms to all prospective investors (prior to them investing) and existing investors (on an annual basis) regarding all preferential treatment the adviser or its related persons provide to other investors in the same fund.***
***For an illiquid fund, notice must be provided as soon as reasonably practicable following the end of the fund’s fundraising period; for a liquid fund, notice must be provided as soon as reasonably practicable after the investor invests into the private fund.
The rules attempt to prevent the preferential treatment of some investors over others, but don't fully ban private side agreements with LPs as originally proposed. Existing private side letter agreements can stay in place. Instead, they demand complete disclosure of these agreements to all investors, but only when the investor finalizes their commitment. If a fund investor commits and later investors get better terms, the fund investor can't renegotiate its terms.
In the future, GPs might avoid giving specific LPs redemption or portfolio information rights due to unclear impacts on others. GPs will need to share rights given to major LPs and "material economic terms" with potential investors. This compels disclosing side agreement terms that might stay hidden, allowing LPs to demand similar rights. For bigger LPs, restrictions might lead GPs to withhold certain benefits to keep information private. Smaller LPs, however, gain more transparency about others' terms, which could improve negotiations.
Compliance date:
- Advisers with US$1.5 billion or more in AUM attributable to private funds: 12 months after publication in the Federal Register, meaning no earlier than August 24, 2024.
- Advisers with less than US$1.5 billion in AUM attributable to private fund assets: 18 months after publication in the Federal Register, meaning no earlier than February 24, 2025.
Books and Records Rule Amendments
The Books and Records Rule Amendment requires RIAs to retain books and records related to the Quarterly Statement Rule, the Audit Rule, the Adviser-Led Secondaries Rule, the Preferential Treatment Rule and the Restricted Activities Rule.
In addition, all RIAs must make and preserve written documentation of their annual internal compliance reviews (this requirement amended the current Advisers Act Compliance Rule), which the SEC may inspect upon request.
Compliance: 60 days after publication in the Federal Register, meaning no earlier than October 24, 2023
Do I have to amend all of my agreements to comply with the Final Rules?
The SEC is providing legacy status for the prohibition aspects of the Preferential Treatment Rule and the aspects of the Restricted Activities Rule that require investor consent. However, to be grandfathered in, you must have entered into the applicable governing agreements prior to the compliance date if the applicable rule would require the parties to amend the agreements. This applies to both RIAs and ERAs.
Glossary:
Exempt Reporting Advisers (ERAs): advisers who are unregistered and exempt from registration. Fund: an entity created to pool money from multiple investors (i.e., LPs). Each investor makes an investment in the fund by purchasing an interest in the fund, and the adviser uses that money to make investments on behalf of the fund. Traditional venture funds typically invest in businesses in exchange for equity and may specialize in particular industries or in companies at a particular stage (e.g., early, mature, or later stage).
Fund of Funds: an investment fund that invests in other types of funds, i.e., its portfolio consists of investments in other funds.
General Partners: managers of private funds.
Illiquid Fund: described by the SEC as a private fund that (1) is not required to redeem interests upon an investor’s request and (2) has limited opportunities (if any) for investors to withdraw before termination of the fund. Most venture capital investments are illiquid because they don't have a secondary market (i.e., private equity).
Limited Partners (LPs): investors in private funds.
Limited Partner Advisory Committee (LPAC): a committee that oversees the management of the venture capital fund and its related entities, including by advising the GP on specific issues throughout the fund’s lifetime such as conflicts of interest and material changes to the governing documents of the fund where LPs’ consents or approvals are required. Each LPAC has different roles, responsibilities and authority, which will be outlined in the venture capital fund’s governing document (i.e., the Limited Partnership Agreement (LPA)).
Liquid Funds: funds that are easily tradeable.
Registered Investment Advisers (RIAs): advisers who are registered or required to be registered with the SEC.
Related Persons: all officers, partners, directors, or those performing similar functions, all persons directly or indirectly controlling or controlled by the advisers, all current employees (other than clerical/admin), and any person under common control with the adviser.