SEC private fund advisers rule boosts investor protection

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Scope

Portions of the final rules apply to different groups of advisers:

The timing of rules implementation depends on the size of the adviser. “Larger private fund advisers” are defined as those with $1.5 billion or more of private fund assets under management, as of the most recent fiscal year-end.

Registered private fund advisers, but not exempt reporting advisers

Quarterly statement rule. Registered private fund advisers must provide private fund investors with a quarterly statement of fund-level information including performance, costs of investing, fees and expenses paid by the fund, and payments made to the adviser. Statement information will include compensation from private fund and portfolio investments to advisers (or the advisers’ related persons) during the reporting period, with separate line items for each category of compensation, including amounts of offsets or rebates carried forward. Quarterly statements are to be distributed 45 days after each of the first three fiscal quarter-ends and 90 days after the fiscal year-end.

Private fund audit rule. All private funds must undergo a financial statement audit, including those private funds that currently rely on the exemptive provisions of the surprise custody examination requirement of the custody rule (Rule 206(4)-2 of the Investment Advisers Act of 1940).

Crowe observation: Today, many, but not all, private funds obtain an annual audit under their governing documents; however, the SEC final rules require that all private funds provide audited financial statements to investors within 120 days of the fund’s fiscal year-end (longer for certain funds of funds) and promptly upon liquidation of each private fund. The independent public accountant performing the financial statement audit must be Public Company Accounting Oversight Board (PCAOB) registered and subject to regular inspection, but the auditor typically will follow U.S. generally accepted auditing standards (U.S. GAAS) to perform the audit. The final rules also require the auditor to follow SEC independence rules.

Adviser-led secondaries rule. An adviser must obtain a fairness or a valuation opinion from an independent opinion provider when the adviser initiates a transaction that offers fund investors the choice between:

• Selling all or a portion of their interest in the private fund
• Converting or exchanging their interest into another fund advised by the adviser or its related persons

Advisers also must provide written disclosure to investors about any material business relationship between the adviser (or its related persons) and the fairness or valuation opinion provider in the previous two years.

Crowe observation: The final rules provide specific definitions of both “related persons” and “independent valuation provider,” among other key terms. In addition, the final rules observe that audit, consulting, capital raising, investment banking, and other similar services might be a material business relationship.

Books and records rule amendments. Advisers are required to retain books and records for the quarterly statement, private fund audit, adviser-led secondaries, restricted activities, and preferential treatment rules.

Crowe observation: Quarterly statements and audited annual financial statements can be distributed electronically or by paper, and the final rules do not require tagging of required disclosures using extensible business reporting language (XBRL). If an adviser is unable to deliver audited financial statements by the deadline due to reasonably unforeseeable circumstances, the SEC does not believe there is a basis for enforcement action if the adviser reasonably believed that the audited financial statements would be distributed on time and the adviser delivers the financial statements as promptly as practicable.

All private fund advisers

Restricted activities rule. Private fund advisers are restricted from the following, unless the adviser provides the appropriate disclosures or, in some cases, obtains investor consent:

• Charging fees to the fund for:
  • Expenses of any regulatory investigation of the adviser (charging fees from an actual court or government sanction is prohibited, regardless of any disclosure or consent)
  • Regulatory examination or compliance fees, or related expenses of the adviser
• Reducing the amount of an adviser's performance-based compensation clawback for actual, potential, or hypothetical taxes
• Allocating portfolio investment fees on a non-pro rata basis, unless the allocation is fair and equitable and written notice of the non-pro rata allocation with a description of how it is fair and equitable is distributed prior to such an allocation
• Borrowing money, securities, or other private fund assets, or receiving a loan or an extension of credit from a private fund client

Preferential treatment rule. Advisers are prohibited from providing:

• Preferential redemption rights that the adviser reasonably believes will have a material, negative impact on other investors, unless required by law or the redemption rights have been offered to all investors
• Preferential information related to portfolio holdings or exposures that the adviser reasonably believes will have a material, negative impact on other investors, unless offered to all investors
• Preferential rights with material economic terms, unless advance written notice is provided to prospective investors and written notice is provided to current investors
• Other preferential rights, unless all investors are provided written notice:
  • For illiquid funds – as soon as reasonably practicable following the end of the private fund’s capital-raising period
  • For liquid funds – as soon as reasonably practicable following the investor’s investment in the private fund

Crowe observation: Certain aspects of the restricted activity and preferential treatment rules are grandfathered in if the fund governing agreements were finalized and the fund commenced operations prior to the compliance date and if complying with the final rules would require modification to the agreements. Annually, the adviser must provide written notice specifying any preferential treatment provided by the adviser or its related persons to other investors in the private fund since the previous written notice.

All registered advisers

Compliance rule amendments. All SEC-registered advisers must annually document in writing adequacy and effectiveness of their compliance policies and procedures.

Compliance dates

The federal register published the final rules on Sept. 14, 2023.

Going forward

These are some near-term considerations for management and those charged with governance:

• Governance. Are new policies and procedures needed to comply with the final rules? Will any changes to audit services be required to comply with SEC independence rules?
• Controls and procedures. What controls and procedures are necessary to comply with the final rules? How will the final rules be considered when drafting governing documents for new funds commencing operations after the compliance dates? What controls are required to ensure prompt and accurate reporting.
• Transition. How will management evaluate progress toward adoption of the final rules prior to the compliance dates? Will implementation and ongoing compliance require engaging third parties? Will consultants or legal counsel with different skill sets be needed?