Restrictions, Prohibitions and Mandates of the SEC’s Private Fund Rules

Disclaimer: On June 5, 2024, the United States Court of Appeals for the Fifth Circuit vacated in its entirety the SEC’s package of private fund adviser rules, which had been enacted in August 2023. It is unclear what further action the SEC will take in response to the Court’s decision. The article below was written in response to the then-enacted rules and no longer reflects Kroll's guidance.

Over a year after its initial proposal, the SEC voted to adopt rule changes relating to the private fund industry on Wednesday, August 23, 2023. The new rules will provide investors with additional information about their private fund investments and provide them with enhanced control over certain activities, fees and expenses engaged in by private funds and their advisers.

The final rules retain many of the core themes of the proposal, such as increasing transparency for private fund investors, and requiring enhanced disclosure by private fund advisers. Notably, the SEC exempted securitized asset funds from each rule other than the compliance rule discussed below. As adopted, the rules will require SEC-registered private fund advisers to:

• Distribute quarterly statements to private fund investors that disclose information about the fund’s performance, fees and expenses charged or allocated to the fund, adviser compensation, as well as certain other compensation paid by the fund or by the fund’s portfolio investments to the adviser or the adviser’s related persons (“Quarterly Statement Rule”). The emphasis on quarterly performance implicitly adds pressure to improve the rigor with respect to quarterly valuations.
• Receive a financial statement audit which meets the requirements of the audit provision of the custody rule on at least an annual basis and distribute the audited financial statements to private fund investors in accordance with the custody rule’s requirement (“Private Fund Audit Rule”).
• Obtain and distribute an independent financial opinion in the form of a Fairness Opinion or Valuation Opinion when offering existing fund investors the option between selling their interests in an existing fund or exchanging their interests for interests in a new vehicle (commonly known as an adviser-led secondary) and prepare a written summary of any material relationships or business arrangements the adviser has had within the prior two years with any service provider engaged to provide a fairness or valuation opinion in relation to an adviser-led secondary for investors (“Advisor-Led Secondaries Rule”).

The Quarterly Statement Rule provides for different information to be included in the required statements depending on the classification of a private fund as “liquid” or “illiquid.” Advisers will need to undertake an analysis of each private fund they advise to determine whether the fund is “liquid” or “illiquid” and document such analysis in accordance with the revised books and records requirements. When considering whether a fund is “liquid” or “illiquid,” advisers should consider the redemption provisions of the fund and any governing documents, the structure of the fund (e.g., open-end or closed-end), and the withdrawal opportunities provided to investors. 

Increased transparency into compensation, fees, expenses and performance will enable investors in private funds to make easier comparison between different advisers as well as between funds in which they may invest. Further, the Quarterly Statement Rule will allow private fund investors to better understand the various fees and expenses charged or allocated to private funds.

In summary, SEC-registered advisers to private funds, other than securitized asset funds, will have the following obligations under the new rules:

The SEC also adopted changes to the books and records requirements under the Advisers Act to facilitate examination of private fund adviser compliance with the new rules.

In addition to the requirements discussed above, the final rules restrict all private fund advisers (“Restricted Activities Rule”), including those who are not registered with the SEC, from engaging in certain activities such as:

• Charging or allocating fees and expenses associated with an investigation of the adviser, such as an SEC enforcement action, without disclosure and consent from the private fund’s investors
• Charging or allocating to a private fund, fees or expenses associated with regulatory, compliance and associated costs unless such fees and expenses are disclosed to the private fund’s investors
• Charging or allocating fees or expenses related to an investment by an adviser’s private fund clients on a non-pro rata basis unless the allocation is fair and equitable and the adviser provides advance written notice of the non-pro rata allocation, including a description of how the allocation is fair and equitable under the circumstances
• Borrowing or receiving lines of credit from a private fund client without disclosing the arrangement to the private fund’s investors and receiving consent
• Reducing an adviser’s clawback of distributions by the amount of certain taxes without disclosing the pre- and post-tax amount of the clawback

Where required by the Restricted Activities Rule to obtain investor consent, advisers will be required to obtain approval from a majority of investors that are not related to the adviser calculated by their interest in the fund. The adopting release specifically notes that due to the SEC’s perceived limitations on Limited Partner Advisory Committees (“LPACs”) and similar advisory committees that certain funds employ, consent by an LPAC or similar group does not suffice under the newly adopted rules.

The Restricted Activities Rule softens many of the original proposal’s outright prohibitions in favor of a disclosure and consent approach. Adviser disclosure of the practices described in the Restricted Activity Rule will allow greater transparency for investors and enhance investor protection against certain problematic practices.

In summary, the Restricted Activities Rule requires:

The final rules additionally address certain activities which provide preferential treatment to some, but not all, investors in a private fund (“Preferential Treatment Rule”). The new Preferential Treatment Rule will prohibit private fund advisers, regardless of registration status, from directly or indirectly providing preferential terms to investors in a private fund or similar pool of assets which the adviser reasonably believes will have a material negative effect on other investors regarding:

• Redemptions from the private fund, unless required by applicable law or the adviser offers such preferential redemption rights to all other investors without qualification
• Information rights relating to portfolio holdings or exposure, unless such information rights are provided to all investors without qualification

Whether a pool of assets is considered a “similar pool of assets” under the Preferential Treatment Rule will require advisers to carefully consider the circumstances of each pool of assets they advise. The adopting release clarifies that a pool of assets could include pools such as parallel funds, limited liability companies, partnerships, feeder funds and alternative investment vehicles, among others. Advisers should review the investment policies, objectives, restrictions and strategies of each pool when assessing the similarities or differences among pools.

The new Preferential Treatment Rule further prohibits private fund advisers, regardless of registration status, from directly or indirectly providing any preferential treatment to investors unless material economic terms are disclosed in advance of an investor’s investment in a private fund and all terms are disclosed after the investor’s investment. The disclosure obligation applicable to material economic terms applies to an investor’s initial investment in a private fund and to any follow-on or add-on investments such investor may make in the private fund.

Advisers will be required under the Preferential Treatment Rule to disclose to investors all preferential treatment granted by the adviser or its related persons on an annual basis and at certain other times based upon the type of private fund.

The Preferential Treatment Rule’s enhanced transparency for private fund investors will allow investors to better understand the operations of a private fund and terms which they may not have originally been provided when investing in a fund. The SEC hopes the Preferential Treatment Rule will provide investors with increased information to better assess any conflicts which may arise with regards to their investment in a private fund.

In a change from the original proposal, the SEC will provide legacy status or grandfather-in private funds, which would be required to amend their governing documents to comply with the changes regarding the prohibitions contained in the Preferential Treatment Rule and the provisions of the Restricted Activities Rule (which require investor consent). However, such legacy status will not be afforded with regards to the annual disclosure of preferential terms required under the new rule.

In addition to the changes affecting private fund advisers, the SEC adopted changes to the compliance rule to require that all registered investment advisers document in writing the annual compliance review required by the compliance rule. Written documentation of the annual compliance review will assist the SEC in assessing an adviser’s compliance with the Advisers Act, and the rules thereunder, and identifying potential compliance weaknesses.

The new rules will be effective 60 days after publication in the Federal Register. Compliance by all registered advisers with the changes to the compliance rule, requiring written compliance program reviews, will be required immediately upon such rule’s effective date. Compliance with the new Private Fund Audit Rule and the Quarterly Statement Rule will be required 18 months after such rule’s date of publication in the Federal Register.

The SEC is adopting a staggered compliance date for the Adviser-Led Secondaries Rule, the Preferential Treatment Rule and the Restricted Activities Rule based upon an adviser’s private fund assets under management. Advisers with $1.5 billion (bn) or more in private fund assets under management will have a 12-month transition period. Advisers with less than $1.5 bn in private fund assets under management will have an 18-month transition period.

Private fund advisers’ compliance obligations will be significantly increased as a result of the SEC’s new rules. Kroll’s compliance and valuation professionals are helping clients to evaluate the impact these new rules will have on their businesses and what changes, if any, must be made to comply with the new regulations.

¹As used herein and in the adopting release, “private fund” shall not include securitized asset funds.
²In all cases, any consent required from investors must be received prior to the consummation of the action (e.g., the charge of fees and expenses to a fund or the borrowing of fund assets by an adviser).
³The Restricted Activities Rule prohibits in all cases an adviser from charging or allocating fees and expenses associated with an investigation of the adviser or its related persons which results in a court or governmental agency finding that the adviser or its related persons violated the Advisers Act or any of the rules thereunder.