SEC Proposes Significant New Rules for Private Fund Advisers

The Securities and Trade Fee (the SEC) on 9 February 2022 proposed new guidelines and amendments (collectively, the Proposed Rules) underneath the Funding Advisers Act of 1940, as amended (the Advisers Act).Importantly, sure of the Proposed Rules would tremendously develop regulatory compliance obligations for all funding advisers to personal funds, together with exempt reporting advisers, overseas non-public advisers and different funding advisers to personal funds that aren’t in any other case required to register with the SEC (for instance, state registrants) (collectively, non-public fund advisers).

The SEC usually designed the Proposed Rules to: (i) present non-public fund traders with elevated transparency, and (ii) prohibit non-public fund advisers from partaking in sure practices that the SEC has recognized as significantly vulnerable to conflicts of curiosity and areas of enhanced investor threat. The Proposed Rules are topic to public assessment and remark till 25 April 2022. The SEC has proposed a transition interval of 1 yr following the issuance of ultimate guidelines to offer non-public fund advisers with time to come back into compliance with the Proposed Rules. 

Whereas the Proposed Rules are nonetheless within the remark interval, non-public fund advisers and traders alike ought to familiarize themselves now with the various adjustments that the Proposed Rules would impose. Up to now there have been roughly 80 remark letters submitted to the SEC.Though trade teams and others doubtless will proceed to submit feedback, absent vital trade enter, we count on that the Proposed Rules will considerably impression the flexibility of subtle non-public fund traders to barter phrases in reference to their investments in non-public funds and, doubtlessly, enhance charges and bills for non-public fund traders to make sure compliance with the Proposed Rules. Specifically, as a result of there isn’t a grandfathering provision contemplated within the Proposed Rules, non-public fund advisers can be required to assessment, and certain amend, present fund paperwork to deliver them into compliance with the Proposed Rules.

PROHIBITED ACTIVITIES

The Proposed Rules would prohibit the next actions for non-public fund advisers, no matter registration standing. Designed to stop perceived conflicts of pursuits recognized by the SEC, the prohibitions signify a cloth departure from the SEC’s historic method to conflicts of curiosity.Particularly, the Proposed Rules would eradicate the flexibility of personal fund advisers to fulfill their responsibility of loyalty by absolutely and pretty disclosing a battle of curiosity and acquiring knowledgeable consent to such battle. As an alternative, the Proposed Rules would successfully prohibit sure conflicts solely after they come up within the context of personal funds, whatever the sophistication of the events concerned or the steps taken to make sure traders perceive the proposed preparations.

Preferential Remedy

In maybe the largest departure from present practices, the Proposed Rules would strictly prohibit sure kinds of facet agreements between non-public fund advisers and traders in a personal fund associated to:

  • Granting preferential liquidity phrases.

  • Offering info relating to portfolio holdings or exposures of the non-public fund to any investor, in every case, if the non-public fund adviser moderately expects that such preferential remedy would have a cloth, detrimental impact on different traders within the fund. 

As well as, the Proposed Rules would prohibit non-public fund advisers from coming into into an settlement with an investor to offer every other sort of preferential remedy with out additionally offering:

  • Written discover to every potential investor that features particular disclosure relating to any preferential remedy.

  • Annual written discover to present traders in an ongoing providing that features particular disclosure relating to any preferential remedy offered by the non-public fund adviser to different traders within the non-public fund. Private fund advisers could adjust to the proposed disclosure necessities by offering copies of facet letters (with traders’ figuring out info redacted) or by offering a sufficiently detailed written abstract of preferential phrases offered.

Issues for Private Fund Advisers

  • Aspect letters: This side of the Proposed Rules represents a major departure from the present follow of many non-public fund advisers and institutional and different traders with respect to facet letters and different comparable written agreements. Reasonably than a privately negotiated facet letter course of, non-public fund advisers can be required to offer all traders and potential traders with particular info relating to preferential phrases of facet letters, including a brand new dynamic to the already advanced negotiation of key phrases. By the identical token, institutional traders which have a developed negotiating technique and a set of facet letter phrases would want to simply accept that such phrases can be particularly disclosed to different traders.

  • “Preferential treatment”: The SEC has not offered steering as to what constitutes “preferential treatment” or “specific” info of such preferential remedy, leaving non-public fund advisers to find out the extent of knowledge to be included in notices to potential and present traders. This lack of readability could result in difficult judgment calls when assessing whether or not, for occasion, noneconomic facet letter phrases represent preferential remedy.

  • Seeding preparations: Many smaller and rising managers forge relationships with one or a handful of “seed” or “anchor” traders, who present outsized capital commitments and contributions of time and experience to assist a supervisor set up itself available in the market. In return, such seed traders are usually given favorable phrases with respect to fund-level investments. Whereas the Proposed Rules would require disclosure of such phrases, the distinctive lively function that seed traders play would distinguish their preparations from these of different traders making a “passive” fund funding. Nonetheless, non-public fund advisers and seed traders might want to contemplate the extent and the impression of disclosures offered to potential traders relating to these preparations and whether or not info rights afforded to seed traders. 

  • Allowances for regulatory necessities: Notably absent from the Proposed Rules is an exception permitting for frequent liquidity phrases and restrictions on receipt of confidential info which might be associated to the regulatory standing of sure kinds of traders, such because the Worker Retirement Revenue Safety Act of 1974 and governmental plans. Inflexibility on this space could have the impact of limiting the universe of funding alternatives for sure courses of traders.

Limiting Legal responsibility and In search of Indemnification 

Underneath the Proposed Rules, a personal fund adviser or its affiliate (together with the non-public fund’s normal accomplice) can be prohibited from in search of reimbursement, indemnification, exculpation, or limitation of its legal responsibility by the non-public fund or its traders for a breach of fiduciary responsibility, willful misfeasance, unhealthy religion, negligence, or recklessness in offering companies to the non-public fund.

This Proposed Rules signify an growth from considerations the SEC has beforehand raised with respect to “hedge clauses” within the context of retail traders. In 2019, the SEC cautioned that “there are few (if any) circumstances in which a hedge clause in an agreement with a retail client would be consistent with those antifraud provisions, where the hedge clause purports to relieve the private fund adviser from liability for conduct as to which the client has a non-waivable cause of action against the private fund adviser provided by state or federal law” however acknowledged that whether or not “a hedge clause in an agreement with an institutional client would violate the Advisers Act’s antifraud provisions will be determined based on the particular facts and circumstances.”The Proposed Rule’s outright prohibition on the inclusion of hedge clauses in non-public fund advisory agreements and governing paperwork represents a departure from this prior view — even essentially the most subtle traders in massive institutional funds can be prohibited from agreeing to the proscribed legal responsibility limitations.

Furthermore, the Proposed Rules wouldn’t simply prohibit hedge clauses that purport to restrict the scope of a personal fund adviser’s non-waivable fiduciary responsibility underneath the federal securities legislation however would additional restrict the flexibility to restrict legal responsibility for acts of negligence (along with willful misfeasance and unhealthy religion). As a result of the conduct that helps a discovering of gross negligence usually constitutes extra critical and extra clearly definable misconduct than negligence, if adopted as proposed, non-public fund managers will doubtless be required to amend present funding administration agreements and personal fund governing paperwork, which usually restrict the non-public fund adviser’s legal responsibility besides to the extent that the non-public fund adviser has acted with gross negligence. As well as, the Proposed Rules’ prohibition doesn’t seem restricted to prohibiting indemnification upon an unbiased willpower that the prohibited conduct constitutes negligence, doubtlessly opening up the doorways to a broad set of disputes as as to whether the non-public fund adviser’s conduct constituted negligence in any respect.

Sure Non-Professional Rata Payment and Expense Allocations

The Proposed Rules would prohibit sure charges and bills associated to a portfolio funding or potential portfolio funding from being charged on a non-pro rata foundation when a number of non-public funds and different shoppers suggested by the non-public fund adviser or its associated individuals have invested or suggest to put money into the identical portfolio funding. Though the Proposed Rules don’t outline “pro rata,” they seem to ponder professional rata allocations based mostly on capital that traders both have invested or have dedicated to take a position. Notably, the Proposed Rules would require non-public fund advisers to allocate charges and bills on a professional rata foundation no matter whether or not a portfolio funding is consummated, that means that “broken deal” bills would have to be allotted amongst all proposed contributors in an funding, together with co-investors.

Issues for Private Fund Advisers

The Proposed Rules may have vital ramifications for non-public fund advisers that make the most of co-investment autos to lift extra capital for portfolio funding offers. As a result of the non-public fund adviser can be required to cost any co-investment automobile its professional rata share of the charges and bills related to any unconsummated funding during which the co-investment automobile “proposed” to take a position, non-public fund advisers might want to face the difficult query of whether or not and when a co-investor has proposed to put money into a deal, they usually can also face difficulties attracting the extra capital wanted to consummate sure investments. Equally, restricted companions that search single deal co-investment alternatives in funds during which they’re invested could also be requested to conform to pay their professional rata share of charges and bills related to damaged offers in these funds. From an administrative standpoint, non-public fund advisers could have challenges allocating charges and bills on a professional rata foundation for unconsummated portfolio investments, particularly within the context of multi-deal co-investment autos, they usually can also face hurdles gathering bills from potential co-investors if a co-investment deal doesn’t shut. 

Charging Charges for Unperformed Companies

The Proposed Rules would prohibit a personal fund adviser from accelerating or charging a portfolio funding for monitoring, servicing, consulting, or different charges for companies that the non-public fund adviser has but to carry out and doesn’t moderately count on to carry out for the portfolio funding.

The Proposed Rules wouldn’t prohibit a personal fund adviser from receiving fee for companies that the non-public fund adviser has truly offered, nor would it not prohibit a personal fund adviser from receiving prepayments for companies that it moderately expects to offer sooner or later. The non-public fund adviser, nonetheless, can be required to refund any quantity paid for companies that it in the end didn’t carry out. 

There’s a restricted exception to the prohibition that may permit a personal fund adviser to shift 100% of the advantage of an accelerated portfolio funding payment to traders within the non-public fund by way of an offset, rebate, or comparable mechanism. 

Issues for Private Fund Advisers

  • Offsets in extra of administration charges: The offset exception would solely apply the place the non-public fund adviser is ready to offset or rebate the total quantity of the accelerated portfolio funding payment. The place offsets exceed administration charges payable to the non-public fund adviser, nonetheless, sure traders could waive receipt of any such extra as a consequence of tax causes. As well as, the place a personal fund adviser already makes use of a administration payment offset to fund some or the entire normal accomplice’s capital dedication to the fund, the quantity to be rebated on the finish of the time period of the fund because of accelerated portfolio funding charges could also be fairly massive, and the non-public fund adviser would want enough liquidity to fund it.

  • “Reasonably expects” customary: Whereas a commonsense method to the “reasonably expects” customary could also be helpful in some cases, it isn’t all the time the case {that a} non-public fund adviser will know, on the time an acceleration clause is triggered, whether or not it “reasonably expects” to offer sure companies for which the portfolio funding is prepaying. As an illustration, the non-public fund adviser and the portfolio firm could legitimately and “reasonably expect” to carry out companies that then, for occasion, develop into pointless due to modified circumstances. The SEC has invited touch upon whether or not the Proposed Rules ought to permit a personal fund adviser to cost charges for companies it doesn’t moderately count on to offer, as long as the non-public fund adviser satisfies sure disclosure, governance, or different situations, equivalent to approval by the non-public fund’s restricted accomplice advisory committee or different governing physique, or disclosure to traders within the related funds. Regardless, underneath the Proposed Rules, non-public fund advisers might want to fastidiously contemplate structuring consulting and comparable relationships with portfolio firms, appropriately memorializing the rationale and phrases of such relationships, and, the place required, offering acceptable disclosure in fund paperwork.

Lowering Clawback Quantities by Taxes

The Proposed Rules would prohibit a personal fund adviser from offering for a clawback of carried curiosity internet of taxes, whether or not internet of precise taxes or internet of a set price of tax. If this prohibition had been adopted, non-public fund advisers would want to revisit all clawback calculations for funds nonetheless in existence to regulate any clawback quantities as a consequence of traders within the fund.

Clawback provisions are typical in non-public fairness and enterprise capital funds the place carried curiosity is paid on an interim foundation. Calculating such provisions on a post-tax foundation is frequent, in recognition of the truth that recipients of carried curiosity should pay such taxes and sometimes won’t be able to recoup tax funds within the occasion of a clawback. Adoption of the Proposed Rules would require non-public fund advisers to reassess how and when carried curiosity is allotted to recipients and with what disclosures relating to tax penalties and return obligations. A carried curiosity recipient could however derive a tax profit from a capital loss upon fee of the clawback, to the extent the capital loss can offset unrelated capital positive factors within the clawback yr or be carried ahead. Thus, the place the Proposed Rules would enhance a clawback it could additionally enhance the potential tax profit associated to the fee.

Borrowing From a Private Fund Consumer

The Proposed Rules would additionally prohibit a personal fund adviser from borrowing any belongings or in any other case in search of an extension of credit score from a personal fund consumer. We observe that, in follow, such principal transactions are usually prohibited underneath most non-public fund paperwork at the moment; sure funds, nonetheless, permit these kind of transactions topic to advisory committee approval, which might not be obtainable. The Proposed Rules wouldn’t prohibit non-public fund advisers from establishing a subscription line of credit score on behalf of the fund if a third-party lender funds the road.

Private Fund Adviser-Associated Compliance Charges and Bills

The Proposed Rules additionally search to ban non-public fund advisers from charging non-public funds for charges and bills related to the regulatory and compliance actions of the non-public fund adviser or its associated individuals, together with bills incurred in reference to examinations or investigations by a regulatory or governmental authority. Within the Proposing Launch, the SEC distinguishes between charges and bills instantly associated to the compliance actions of a personal fund, which a personal fund adviser can be permitted to move by way of to a fund, and charges and bills incurred by the adviser in reference to examinations or investigations of the non-public fund adviser or the regulatory or compliance charges of the non-public fund adviser or its associated individuals, equivalent to these related to making ready and submitting the non-public fund adviser’s Type ADV.

Over the previous a number of years, it has develop into extra frequent for non-public fund advisers, and significantly rising and mid-sized non-public fund advisers, expressly to offer for a portion of compliance and regulatory bills to be paid for by the funds they handle by together with such bills within the definition of partnership bills. The Proposed Rules would finish this follow.

Issues for Private Fund Advisers

  • Impact on clawbacks and carried curiosity: As beforehand famous, the Proposed Rules would create an obligation on behalf of personal fund advisers to rethink each (i) how clawback quantities are calculated for their preexisting funds, and (ii) when and the way their funds allocate carried curiosity to carried curiosity recipients. Any course of adjustments in mild of this second consideration may additionally require corresponding updates to providing doc disclosure on carried curiosity.

  • Identification of bills: Though the SEC’s steering delineating the remedy of personal fund adviser-related and fund-related compliance bills is useful, in follow the excellence between non-public fund adviser and fund charges and bills may be very unsure. That is very true in a scenario the place a personal fund adviser could allocate such bills amongst a number of non-public funds. For instance, bills related to a compliance system that’s solely used to trace permissible investments for a number of non-public funds may moderately be thought of a personal fund adviser expense or an expense instantly associated to the administration of the related non-public funds. Within the Proposing Launch, the SEC instructed that, the place an expense shouldn’t be clearly a personal fund adviser or a fund expense, the non-public fund adviser “generally should allocate such fees and expenses in a manner that it believes in good faith is fair and equitable and is consistent with its fiduciary duty.”

  • Disclosures: The SEC has invited touch upon whether or not it ought to make an exception for conditions the place a personal fund adviser discloses to traders that the fund will bear such charges and bills. Pending any extra steering, non-public fund advisers ought to take a chance to assessment what charges and bills they at the moment allocate to personal funds in addition to associated disclosures to traders. 

REQUIRED QUARTERLY REPORTING

The Proposed Rules would require a registered non-public fund adviser to distribute a quarterly assertion to personal fund traders that features, in desk format at each the fund degree and the portfolio degree: 

  • An in depth accounting of all charges and bills paid to the non-public fund adviser and/or its associated individuals, together with any administration payment offsets.

  • Every other charges and bills that portfolio investments pay to the non-public fund adviser and its associated individuals.

  • Sure portfolio firm possession and efficiency info, together with: 

    • For open-end funds, annual internet complete returns since inception, common annual internet complete returns, and quarterly internet complete returns.

    • For closed-end funds, gross and internet inner price of return and gross and internet a number of of invested capital. 

The non-public fund adviser can be required to distribute these experiences to traders inside 45 days following the top of the relevant quarter. The SEC expects these necessities would decrease the bills of and burden on traders related to monitoring bills, efficiency, and conflicting preparations and enhance traders’ skill to barter fund phrases and consider companies offered by non-public fund advisers and different service suppliers. Of observe, the SEC thought of, however elected to not require, reporting on the investor degree. The dearth of this reporting would blunt the transparency profit that this proposal would offer to traders.

Issues for Private Fund Advisers

During the last a number of years, non-public fund advisers have already got elevated each the frequency and degree of element of reporting to traders in response to elevated investor requests and a normal trade pattern towards larger transparency. Accordingly, the Proposed Rules doubtless wouldn’t end in dramatic operational adjustments for most non-public fund advisers. Private fund advisers ought to contemplate the next:

  • Timing: Private funds generally present quarterly monetary reporting to traders, usually inside 45 to 60 days following the top of the relevant quarter. Private fund advisers would want to evaluate their skill to organize these experiences, which can not at the moment embrace the entire info prescribed underneath the proposed necessities, on a tighter timeline, giving consideration to extra effort and assets that could be wanted the place reporting obligations exceed the non-public fund adviser’s present practices. 

  • Funds of funds: Funds of funds that depend on underlying fund managers for reporting info would profit from extra steering as as to whether the experiences may embrace info based mostly on essentially the most present underlying fund estimates, which may lag by 1 / 4 or extra relying on the underlying fund, or whether or not fund of funds will likely be permitted extra time to offer their experiences, much like the extension that funds of funds obtain to ship their audited financials to underlying traders underneath Rule 206(4)-2 underneath the Advisers Act (the Custody Rule).

  • Providing doc disclosures: Many non-public fund advisers would want to assessment and replace their funds’ governing paperwork for adjustments to the frequency or content material of experiences to traders.

ANNUAL AUDIT REQUIREMENT

The Proposed Rules would require registered non-public fund advisers to acquire and distribute promptly to traders an annual audit of every of their non-public funds, ready in accordance with U.S. GAAP (or, for overseas non-public funds, monetary statements containing considerably comparable info) by an unbiased public accountant registered with and topic to common inspection by the Public Firm Accounting Oversight Board. As well as, a personal fund adviser can be required to enter into an settlement with the auditor requiring the auditor to inform the SEC Division of Examinations if the non-public fund adviser terminates the auditor’s contract or if the auditor points a modified opinion. 

Subadvisers to personal funds would even be required to take “all reasonable steps” to trigger a subadvised non-public fund managed by an unaffiliated non-public fund adviser to endure an audit in satisfaction of the Proposed Rules. 

Issues for Private Fund Advisers

  • Custody rule compliance gaps: The audit requirement largely—although not fully—overlaps with present audit practices of many non-public fund advisers underneath the Custody Rule, such that personal fund advisers that ship audited financials or decide to conduct a shock accounting agency examination for functions of compliance with the Custody Rule won’t routinely be in compliance with the Proposed Rules. Most notably, the Proposed Rules don’t permit non-public fund advisers to make the most of the shock examination choice underneath the Custody Rule in lieu of acquiring an audit.

  • Timing: The Proposed Rules would require that the non-public fund adviser make “prompt” supply of a fund’s audited monetary statements after the completion of the audit, however neither the Proposed Rules nor the Proposing Launch include additional steering as to what timing is required to fulfill this customary, and the SEC elected not present any “specific deadline.” The SEC particularly notes, nonetheless, that the 120-day interval within the Custody Rule won’t essentially fulfill this requirement. 

  • Subadvisers: Subadvisers, particularly third-party subadvisers, to personal funds ought to assessment their subadvisory agreements and relationships to take “all reasonable steps” to require compliance with the audit requirement for every non-public fund that they subadvise. Notably, non-public fund advisers appearing as subadvisers to a personal fund will usually not have custody, as that time period is outlined within the Custody Rule, of the fund, and unregistered non-public fund advisers could object to fund traders bearing the price of an audit to accommodate regulatory necessities imposed on the subadviser by the SEC. Collateral managers of collateralized mortgage obligations (CLOs) also needs to pay shut consideration to this requirement, as many collateral managers additionally take the place that they don’t have custody underneath the Custody Rule, and CLOs typically will not be topic to audit.

ADVISER-LED SECONDARIES REQUIREMENTS

Lastly, the Proposed Rules would require a registered non-public funds adviser, in reference to sure non-public fund adviser-led secondaries, to acquire and distribute prior to shut: 

  • A 3rd-party opinion that the worth the non-public fund adviser affords is truthful (a Equity Opinion).

  • A abstract of fabric enterprise relationships that the non-public fund adviser or its associated individuals has had over the prior two years with the opinion supplier.

The Proposed Rules outline the transactions that may fall inside the scope of those new necessities as transactions that the non-public fund adviser or its associated individuals provoke and that supply traders the choice both to promote their pursuits or to transform or change their pursuits for pursuits in one other automobile that the non-public fund adviser or its associated individuals advise.

For such transactions, non-public fund advisers would want to acquire a Equity Opinion from an unrelated third occasion that gives such opinions within the extraordinary course of enterprise and supply disclosure of the non-public fund adviser’s materials enterprise relationships with the opinion supplier.

Issues for Private Fund Advisers

Private fund advisers ought to contemplate whether or not they interact in transactions that will fall inside the scope of the Proposed Rules. For instance, does the non-public fund adviser actively “commence” a course of supposed to offer liquidity in change for pursuits in a fund or in a continuation automobile? Alternatively, does the non-public fund adviser merely facilitate a secondary sale of a fund curiosity in response to an unsolicited request from traders? If the Proposed Rules are adopted as proposed, non-public fund advisers could contemplate growing insurance policies designed to tell apart one scenario from the opposite.

* * *

In some methods, the Proposed Rules would codify present practices noticed by many non-public fund advisers. However, in lots of different methods, non-public fund advisers will view the Proposed Rules as imposing materials adjustments to their operations, and personal fund advisers and traders, as relevant, will to wish contemplate how the Proposed Rules impression their relationships, the phrases pursuant to which traders make investments, and personal fund advisers’ skills to develop novel funding merchandise tailor-made to investor wants. We anticipate that smaller and rising managers would be the most impacted by most of the Proposed Rules, significantly in reference to capital elevating and the price of compliance.

The authors wish to thank Matt Hevert and Wes Gangi for contributing to the writing of this alert.

ENDNOTES

Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, SEC Release No. IA-5955; File No. S7-03-22, (the Proposing Launch).

The complete record of submitted feedback could also be discovered on the SEC web site. See Comments on Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, SEC Release No. IA-5955; File No. S7-03-22, (final visited Mar. 29, 2022).

See Commission Interpretation Regarding Standard of Conduct for Investment Advisers, SEC Release No. IA-5248; File No. S7-07-18, at n70, (“As discussed above, institutional clients generally have a greater capacity and more resources than retail clients to analyze and understand complex conflicts and their ramifications.”).

Id. at n.31. Earlier this yr, the SEC introduced an enforcement motion in opposition to an funding adviser for together with an inappropriate “hedge clause” in its advisory agreements with retail shoppers. See In re Complete Cap. Mgmt., Inc., Advisers Act Launch No. 5942 (Jan. 11, 2022).

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