In the coming weeks and months, Seward & Kissel LLP will be providing additional analysis of the Final Rules Regarding the Regulation of Private Fund Advisers and their implications for private fund advisers. Further, on September 27 at 12:00pm EDT, we will be hosting a webinar to discuss the Final Rules.

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To view a pdf version of this memo, please click here.

On August 23, 2023, by a vote of 3-2, the Securities and Exchange Commission (the “SEC”) adopted new final 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”). In the adopting release for the Final Rules (the “Adopting Release”), the SEC noted that the Final Rules are designed to protect investors who directly or indirectly invest in private funds by increasing visibility into certain practices involving compensation schemes, sales practices, and conflicts of interest through disclosure; establishing requirements to address such practices that have the potential to lead to investor harm; and restricting practices that are contrary to the public interest and the protection of investors.¹

Effective Date and Transition Matters. The Final Rules will become effective 60 days following publication in the Federal Register (the “Effective Date”). Compliance with the amended Advisers Act compliance rule will be required from the Effective Date. The Final Rules allow for staggered compliance dates for the other requirements ranging from 12 to 18 months from the Effective Date. Specifically, the Final Rules provide for (i) an 18-month transition period for all private fund advisers for compliance with the Audit Rule and the Quarterly Statement Rule, and (ii) staggered compliance dates with transition periods ranging from 12 to 18 months depending on the size of the adviser for the Adviser-Led Secondaries Rule, the Preferential Treatment Rule, and the Restricted Activities Rule.²

As set forth in Section I below, certain of the Final Rules apply only to registered private fund advisers, while others apply to all private fund advisers (i.e., both registered and unregistered advisers, including exempt reporting advisers).³

I. High-Level Summary of Final Rules

Final Rules Applicable to Registered Private Fund Advisers:

• Quarterly Statement Rule. Requires registered private fund advisers to provide private fund investors increased transparency with the distribution of a detailed quarterly statement disclosing fund-level information regarding a private fund’s performance, the cost of investing in the private fund, certain fees and expenses paid by the private fund and compensation paid to the adviser.
• Audit Rule. Requires registered private fund advisers to cause each private fund client to undergo an audit that meets the requirements of the Custody Rule under the Advisers Act⁴.  To the extent an adviser does not control the private fund, the Final Rule requires the adviser to take all reasonable steps to cause the fund to undergo an audit that meets these requirements.
• Adviser-Led Secondaries Rule. Requires registered private fund advisers to obtain a fairness opinion or valuation opinion in connection with an adviser-led secondary transaction⁵ effected between private funds advised by the adviser and/or its related persons.⁶
• Books and Records Rule Amendments. Require registered private fund advisers 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.

Final Rules Applicable to All Private Fund Advisers:

• Restricted Activities Rule. All private fund advisers are restricted from engaging in certain activities and practices that are contrary to the public interest and the protection of investors; provided that some activities are allowed with sufficient disclosures to investors, and in some cases, investor consent. For example:
  • An adviser may not charge fees or expenses related to an investigation that results or has resulted in a court or governmental authority imposing a sanction for a violation of the Advisers Act or the rules promulgated thereunder.
  • An adviser may not reduce the amount of an adviser clawback by the amount of certain taxes, unless the adviser discloses the pre-tax and post-tax amount of the clawback to investors.
  • An adviser may not borrow or receive an extension of credit from a private fund client without disclosure to, and consent from, fund investors.
• Preferential Treatment Rule. All private fund advisers are prohibited from providing preferential terms to investors regarding: (i) redemptions from the fund and (ii) information about portfolio holdings or exposures, in each case if the adviser reasonably expects that it would have a material, negative effect on other investors, except as noted in Section II below. In addition, the Final Rules prohibit all private fund advisers from providing preferential treatment to investors, unless the material economic terms are disclosed in advance of an investor’s investment in the private fund and all preferential terms are disclosed after the investor’s investment. Furthermore, there is also an annual notice requirement as described in Section II below.
• Legacy Status. The SEC is only providing legacy status for the prohibitions aspect of the Preferential Treatment Rule and the aspects of the Restricted Activities Rule that require investor consent (i.e., borrowing from a private fund or charging certain investigation fees and expenses as described in Section II below). The legacy status provisions apply to governing agreements that were entered into prior to the compliance date if the applicable rule would require the parties to amend the agreements.

Final Rules Applicable to All Registered Advisers:

• Compliance Rule Amendments. The Final Rules require all registered advisers, including those that do not advise private funds, to document in writing the annual review of their compliance policies and procedures.

II. Notable Modifications

Notably, the Final Rules modify certain portions of the rules that were originally proposed in February 2022 (the “Proposed Rules”). Directly below are certain high-level points describing how the Final Rules differ from the Proposed Rules.

• Waiver or Indemnification Prohibition. The Final Rules do not contain the “waiver or indemnification prohibition,” which under the Proposed Rules would have prohibited an adviser to a private fund, directly or indirectly, from seeking reimbursement, indemnification, exculpation, or limitation of its 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. In the Adopting Release, the SEC noted that much of the activity that it would have prohibited is already prohibited by an adviser’s Federal fiduciary duty and antifraud provisions.
• Adviser Clawback for Taxes. The Proposed Rules would have prohibited an adviser from reducing the amount of any adviser clawback by actual, potential, or hypothetical taxes applicable to the adviser, its related persons, or their respective owners or interest holders. The Final Rules do not prohibit advisers from engaging in after-tax adviser clawback reductions if advisers satisfy certain disclosure requirements designed to better inform private fund investors of the impact of after-tax adviser clawback reductions.⁷
• Preferential Treatment Rule. The Final Rules have two significant changes from the Proposed Rules:
  • The Final Rules clarify that the preferential redemption right prohibition and preferential information right prohibition regarding portfolio holdings or exposure (i.e., the “prohibitions aspect of the Preferential Treatment Rule”) do not apply if the redemption right or the information, respectively, is offered to all other existing investors in the private fund.⁸ Furthermore, the redemption right prohibition includes an exception if the redemption right is required by law. Notably, the Final Rules provide legacy status under the prohibitions aspect of the Preferential Treatment Rule with respect to private funds that had commenced operations as of the compliance date.⁹
  • The Final Rules limit the Proposed Rules’ requirement to provide advance written notice of preferential treatment to only material economic terms¹⁰ (as opposed to all investment terms). In addition, the Final Rules require the adviser to distribute to current investors a written notice of all preferential treatment the adviser or its related persons have provided to other investors in the same private fund (i) for an illiquid fund, as soon as reasonably practicable following the end of the fund’s fundraising period and (ii) for a liquid fund, as soon as reasonably practicable following the investor’s investment in the private fund.¹¹ Notably, the Final Rules do not provide legacy status to private funds with respect to these disclosure portions of the Preferential Treatment Rule.
• Restricted Activities Rule. In a change from the Proposed Rules, the Final Rules will not prohibit the activities and practices described below, as well as the reduction in the amount of a clawback for taxes as described above, so long as the adviser provides certain disclosure, and in some cases, obtains investor consent.
  • An adviser is permitted to charge or allocate to the private fund fees or expenses associated with an investigation of the adviser or its related persons by any governmental or regulatory authority, provided the adviser (i) requests that each investor of the private fund consents to, and (ii) obtains written consent from at least a majority in interest of the private fund’s investors that are not related persons of the adviser for such charge or allocation; however, regardless of any disclosure or consent, an adviser may not charge or allocate fees and expenses related to an investigation that results or has resulted in a court or governmental authority imposing a sanction for violating the Advisers Act or the rules promulgated thereunder.
  • An adviser is permitted to charge or allocate to the private fund any regulatory or compliance fees or expenses, or fees or expenses associated with an examination, of the adviser or its related persons, provided the adviser distributes a written notice of any such fees or expenses, and the dollar amount thereof, to the investors of such private fund client in writing within 45 days after the end of the fiscal quarter in which the charge occurs.
  • An adviser is permitted to charge or allocate fees and expenses to the private fund 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, provided (i) the non-pro rata charge or allocation is fair and equitable under the circumstances and (ii) prior to charging or allocating such fees or expenses to a private fund client, the adviser distributes to each investor of the private fund a written notice of the non-pro rata charge or allocation and a description of how it is fair and equitable under the circumstances.
  • An adviser is permitted to borrow money, securities, or other private fund assets, or receive a loan or an extension of credit, from a private fund client, provided the adviser: (i) distributes to each investor a written description of the material terms of, and requests each investor to consent to, such borrowing, loan, or extension of credit; and (ii) obtains written consent from at least a majority in interest of the private fund’s investors that are not related persons of the adviser.
  • The Final Rules do not implement a prohibition on fees for unperformed services, as the SEC noted that this activity is contrary to an adviser’s obligations to its clients under the adviser’s Federal fiduciary duty.
• Audit Rule.
  • In a change from the Proposed Rules, the SEC is requiring the audit to comply with the audit provision under the Custody Rule. While the SEC noted that it continues to believe that it is important for audited financial statements to be prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”), the Final Rules clarify that audited financial statements may be prepared in accordance with some other comprehensive body of accounting standards similar to U.S. GAAP if the differences are reconciled to U.S. GAAP.¹²
  • Furthermore, in the Proposed Rules the SEC proposed that the audited financial statements be distributed “promptly” after the completion of the audit. However, the in Final Rules, the SEC noted that it believes that a 120-day time period is generally appropriate to allow the financial statements of a fund to be audited while also balancing the needs of investors to receive timely information.
  • In a change from the Proposed Rules, the Final Rules will not require that auditors notify the SEC (i) promptly upon issuing an audit report to the private fund that contains a modified opinion and (ii) within four business days of resignation or dismissal from, or other termination of, the engagement, or upon removing itself or being removed from consideration for being reappointed.
• Quarterly Statement Rule. In a change from the Proposed Rules, the Final Rules provide that: (i) advisers to illiquid funds are required to calculate performance information with and without the impact of subscription facilities, rather than only without; (ii) the definition of illiquid fund will be based primarily on withdrawal and redemption capability; (iii) instead of requiring advisers to present liquid fund performance since inception, such performance is limited to a 10-year lookback; and (iv) advisers receive additional time for (A) delivery of fourth quarter statements and (B) all statements for funds of funds.¹³
• Adviser-Led Secondaries Rule. In a change from the Proposed Rules, advisers may obtain a fairness opinion or a valuation opinion under the Final Rules. In addition, the Final Rules require that the adviser distribute both the opinion and summary of material business relationships to private fund investors prior to the due date of the election form for the transaction instead of prior to the closing of the transaction.
• Securitized Asset Funds. In the Final Rules, the Quarterly Statement Rule, the Audit Rule, the Adviser-Led Secondaries Rule, the Restricted Activities Rule, and the Preferential Treatment Rule do not apply to securitized asset fund clients.

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If you have any questions regarding the information discussed above, please contact your Investment Management Group attorney at Seward & Kissel LLP.