On Aug. 23, the SEC voted to enact a set of new rules for registered investment advisers (RIAs) offering unregistered private funds. The rules relate to both closed-end funds (for example, private equity funds) and open-end offerings (for example, hedge funds). As with most new federal regulations, the language is somewhat vague as to how it will ultimately be interpreted and implemented, so it will only be formally clarified through the enforcement process. Also, the new rules will apply only to new funds formed, not existing partnerships. The new rules have varying implementation dates with some dependent on the size of the adviser, but generally will take effect within 18 months.

The 3-2 vote was split along political party lines, with Democrats for and Republicans against. The new rules are voluminous (660 pages), so we will provide only a summary of key areas. While still in the process of reviewing and analyzing the implications, the Institutional Limited Partners Association (ILPA) has come out in favor of the new regulations.

Six Key Topics in the SEC 2023 Private Fund Rules

This blog post will address six key topics that most affect institutional investors:

Quarterly Statements

This rule addresses six areas, with the first two of most interest, and it will require additional disclosures not currently included in institutional quarterly statements.

The first covers Fees and Expense Disclosure, which requires the provision of new schedules detailing fees and expenses that make up the adviser’s compensation from all fund-related sources (e.g., from investors and from portfolio companies) including both management fees and performance-based compensation, both cash and in-kind. It will also require detailed schedules of expenses paid by and allocated to the funds that the investors bear. The disclosures must also address offsets, rebates, and waivers.

The second is Performance Disclosure requiring the provision of both gross and net returns in standardized formats. For instance, private equity funds must include both gross and net since-inception IRRs and return multiples. The returns must also be shown with and without the effects of fund-level subscription facilities.

The final four rules are related to more technical presentation requirements, including: preparation and distribution (including timing) of statements; performing financial statement consolidations; formatting and content of statements; and recordkeeping requirements.

Commentary: How private funds generate income for advisers and what expenses are charged to investors (and how) has always been very opaque and complex. The new disclosures will provide voluminous detailed information to investors. Carried interest payment information in particular has been very hard for investors to secure. The challenge for investors will be how to synthesize and make sense of the information in a practical way with available resources. As the variety of practices of charging ancillary fees becomes known, there may also be a curtailing of certain practices and a simplification and convergence of others. Standardized performance calculations will also be beneficial in monitoring and comparing investments. There is a recognition by industry participants and the SEC that the burden of additional reporting will be more expensive across the board and will impact smaller and newer organizations to a much greater degree than larger and established ones.

Mandatory Private Adviser Audits

These rules address eight different topics. In summary, private fund advisers must provide investors with an annual audit of the funds in which they invest, and a final audit upon dissolution. The rule also codifies certain new audit standards. Annual audits of institutional private equity funds by a recognized independent firm are the current industry standard.

However, the rules address auditor requirements that appear to “raise the bar” for auditors in their standards and responsibility for detecting fraud, assessing valuations (particularly for valuations on which fees are calculated), and attesting to the advisers’ return calculations.

Commentary: The SEC states that the new standards will likely increase the costs of audits and may also limit the set of firms that are eligible to perform audits, but it highlights that over 90% of private equity and hedge funds are currently undergoing annual audits, primarily with qualified firms.

Adviser-Led Secondaries

These rules have five sub-sections. The rise of GP-led transactions, particularly continuation vehicles, has presented the industry with an awkward set of conflicts of interest for investors to navigate. The new rule will require the GP sponsoring the transaction to secure either a fairness opinion or a valuation opinion from a qualified independent provider prior to the due date of the election form, including any relationships with the opinion provider during the prior two years. The opinions must consider both selling investors and investors continuing in the new vehicle. The rule also covers records retention requirements related to the transaction.

Commentary: While fairness or valuation opinions that are secured by independent parties paid by the adviser may not be a silver bullet in ameliorating inherent conflicts, having a formal review and documented report by an additional expert party will be helpful to investors in documenting the fulfillment of fiduciary responsibilities, and it may in instances corral overreach by parties with a stronger information advantage. The original proposal included a consideration of the GP-led vehicle’s new terms in the opinion, but that was withdrawn as the SEC felt that overall economics would be captured in the transfer price.

Restricted Activities

This rule relates to five specific practices:

1. Advisers cannot pass through the costs of a governmental investigation of the adviser.
2. The costs of governmental regulatory, examination, or compliance fees or expenses cannot be charged to a fund.
3. After-tax clawback provisions require additional disclosure regarding the investor’s specific dollar amounts including pre-tax, after-tax, and related excess compensation associated with the GP’s over-distribution.
4. Charges associated with company investments (including co-investments) must be allocated to investors participating in the transaction on a pro-rata basis.
5. The adviser may not borrow in any context from fund investor clients.

Commentary: These provisions do not seem particularly controversial and promote greater alignment of interests. The SEC highlighted that the pro-rata allocation rule needed to be codified because GPs persisted in disproportionate expense allocations even after prior guidance and enforcement actions.

Certain Adviser Misconduct

This section covers two items that have long been controversial: 1) Charging Fees for Unperformed Services (e.g., accelerated company monitoring fees), and 2) Limiting or Eliminating Liability (indemnification provisions). While potentially prohibiting these actions was in the original proposed rule, the SEC decided not to implement them, but instead provided clarifying guidance as to how it views these practices. Regarding fees for unperformed services, the prime example is that GPs create multi-year contacts with companies for monitoring, servicing, consulting, or other services; if the company is sold before the contract expires, the GP receives an accelerated lump-sum payment from the company for the remaining contracted fees. These payments can be notably large. The SEC indicated that it did not need to prohibit unperformed service fees because in its view charging such fees is inconsistent with the GP’s fiduciary duty to the fund, and indicated its standard of enforcement would be charging for services “that it does not, or does not reasonably expect to, provide to a client.” This appears to be a prominent warning regarding continued future enforcement actions, but enforcement must be pursued on a case-by-case basis.

It has been generally observed that GPs are increasingly adding contractual language that dilutes their fiduciary responsibility to their funds and investors that are generally applicable to the partnership agreement sections on reimbursement, indemnification, exculpation, and limitation of liability. However, the SEC did not believe that a prohibition on limiting or eliminating liability was necessary to achieve its goals. It instead provided clarification commentary as to its views on an adviser’s fiduciary duty to a fund and how existing Advisers Act anti-fraud provisions may apply. While longer than can be enumerated here, essentially any standard lower than that of federal fiduciary duty would be deemed to violate the Advisers Act.

Commentary: These rules seem to negate any overreaching contractual terms, but since they are not prohibited, they will need to be enforced on a case-by-case basis.

Preferential Treatment

This section was originally highly controversial among limited partner investors as it proposed a prohibition on side-letters, which have historically been valuable documents for limited partners to come to terms with general partners. Side-letters are particularly useful for larger investors to negotiate favorable terms. The section addresses six topics:

1. Prohibited Preferential Redemptions (primarily applicable to hedge funds) requiring all investors to have the same rights to withdraw capital.
2. Prohibited Preferential Transparency requiring all investors to have access to similar portfolio holding information on a similar time basis (primarily targeting hedge funds).
3. Similar Asset Pools relates to a change in previous wording from “Substantially Similar Asset Pool” in order to broaden the applicability of the various investor rights.
4. Other Preferential Treatment and Disclosure of Preferential Treatment, which is the section that relates to side-letters.
5. Delivery
6. Recordkeeping

In the case of the first three, the SEC adopted outright prohibitions and broadened some language. The last two provisions are related to more technical presentation requirements.

Regarding No. 4, Other Preferential Treatment and Disclosure of Preferential Treatment, the SEC decided not to ban side-letters, but to increase disclosure requirements. The requirements are that “any preferential treatment related to any material economic terms” (i.e., including, but not limited to, the cost of investing, liquidity rights, fee breaks, and co-investment rights) needs to be provided by advance written notice prior to the investor’s investment in the fund. All other preferential treatment must be disclosed for closed-end funds in writing to current investors as soon as reasonably practicable following the end of the fundraising period, and for liquid funds, as soon as reasonably practicable following the investor’s investment in the private fund.

Commentary: The new disclosure requirements provide enhanced pre-close transparency that may benefit investors which can successfully argue that they qualify for the same terms negotiated by investors that are driving economic concessions (generally based on commitment size). It also affords full transparency on all concessions to investors, which may reduce, or at least highlight, potential conflicts of interest and differing treatment of investors in the same fund. Many funds have most favored nation (MFN) provisions, in which after the final close the GP distributes a list of concessionary side-letter provisions that investors can then opt into if they qualify as being sufficiently similar to the investor that secured the arrangement (generally related to commitment size). The new rules formalize fuller disclosure and the ability of investors to be aware of material terms differences before they close.

For those interested, the following is a link to the Final Rules document:

https://www.sec.gov/files/rules/final/2023/ia-6383.pdf