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SEC Announces Major Rule Changes for Private Funds

20th Sep 2023
New regulations are going into effect – here’s what fund advisers should be doing right now to comply.

On Wednesday, August 23rd, the SEC voted to approve a set of new rules and amendments to the Investment Advisers Act of 1940. In order to “enhance the regulation of private fund advisers,” these rules require new types of disclosures, prohibit certain activities deemed “contrary to the public interest,” and institute requirements for reviews of compliance policies.

These amendments amount to some of the largest changes to private fund regulations in decades, and fund managers may be uncertain about which elements apply to them and when they have to comply. The major changes can be divided into three categories, which affect funds in different ways.

Transparency rules

The amendments regarding transparency apply to all private fund advisers registered with the SEC, and are broken down into four parts:

Quarterly Statement Rule: registered fund advisers must distribute a quarterly statement to fund investors that discloses fund-level information regarding performance, the cost of investing in the fund, fees and expenses paid by the fund, and all compensation paid to the adviser and its related persons. The quarterly statement rule imposes different delivery deadlines for fund of funds vs. non-fund of funds. Mandatory performance reporting requirements also vary between liquid and illiquid funds.

Private Fund Audit Rule: all funds must undergo a yearly financial statement audit that “meets the requirements of the audit provision in the Advisers Act custody rule (rule 206(4)-2)).”

Adviser-Led Secondaries Rule: occasionally, private fund advisers will offer existing fund investors “the option between selling their interests in a private fund and converting or exchanging their interests in the private fund for interests in another vehicle advised by the adviser or any of its related persons.” In these cases, advisers will be required “to obtain a fairness opinion or a valuation opinion.”

This is to guard against conflicts of interest and have a third-party check on the adviser’s valuation. It also requires disclosure of any material business relationships the adviser has had in the prior two years with the opinion provider.

Books and Records Rule Amendments: according to the SEC, “To facilitate the Commission’s ability to assess an adviser’s compliance with the rules, the reforms include amendments to the books and records rule under the Advisers Act for registered private fund advisers.” This amendment deals with retaining records related to the other adopted provisions.

For some funds, these increases in disclosures, statements, and audits will require a substantial increase in labor in order to provide them. Each category has specific information that must be provided and how it must be provided, so expertise in this type of reporting will be more valuable than ever. Efficient fund administration will be necessary to avoid greatly increased expenses related to this reporting.

While the above transparency rules apply to registered private fund advisers, other categories of new rules apply to all private fund advisers.

Restricted activities

These rules are “to address certain conflicts of interest that have the potential to lead to investor harm” and prohibit the following:

Charging or allocating to the private fund fees or expenses associated with an investigation of the adviser without disclosure and consent from fund investors. Further, 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;

Charging or allocating to the private fund regulatory, examination, or compliance fees or expenses of the adviser, unless such fees and expenses are disclosed to investors;

Reducing 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;

Charging or allocating fees or expenses related to a portfolio investment on a non- pro rata basis, unless the allocation approach is fair and equitable and the adviser distributes advance written notice of the non-pro rata charge and a description of how the allocation approach is fair and equitable under the circumstances; and

Borrowing or receiving an extension of credit from a private fund client without disclosure to, and consent from, fund investors.

Note that for many of these activities, there is an exception if the actions have been disclosed to investors. Under the proposed rule, some of these activities were to be completely banned, but the final rule provides disclosure-based exceptions. These disclosures must be performed properly and records kept so advisers can prove investors were informed of the activity – another aspect where the right fund administrator can help.

Preferential treatment

As stated by the SEC, this section prohibits “certain types of preferential treatment that have a material negative effect on other investors and prohibit other types of preferential treatment unless disclosed to current and prospective investors.”

As for what constitutes preferential treatment, this section will affect side letter agreements which allow certain investors to make redemptions that are not offered to other investors. However, it may be possible to offer certain types of preferential treatment if “certain terms are disclosed in advance of an investor’s investment in the private fund and all terms are disclosed after the investor’s investment.” Once again, transparency is key: the more information a fund provides to its investors, the more leeway it may have.

Which rules apply to which funds, and how soon do funds have to comply?

The prohibitions aspect of the Preferential Treatment Rule and the portions of the Restricted Activities Rule that require investor consent are given “legacy status,” which applies to “governing agreements that were entered into prior to the compliance date if the applicable rule would require the parties to amend the agreements.” This is good news for advisers concerned about retroactively having to amend investor agreements. That said, it doesn’t affect the transparency provisions.

There is also a set of compliance rule amendments which state that all advisers – even those who do not advise private funds – must “document in writing the required annual review of their compliance policies and procedures.” While the other new rules do not apply to securitized asset funds, this one does. It’s important for advisers to thoroughly understand the amendments to be sure of which ones apply to them.

How soon do advisers need to comply to these new rules? It depends on the size of the fund and the rules in question:

For the Private Fund Audit Rule and the Quarterly Statement Rule, the compliance date will be 18 months after the date of publication in the Federal Register. For the Adviser-Led Secondaries Rule, the Preferential Treatment Rule, and the Restricted Activities Rule, the compliance dates are: for advisers with $1.5 billion or more in private funds assets under management, 12 months after the date of publication in the Federal Register; and for advisers with less than $1.5 billion in private funds assets under management, 18 months after the date of publication in the Federal Register. Compliance with the amended Advisers Act compliance rule will be required 60 days after publication in the Federal Register.

The quickest rule that must be complied with is the updated compliance rule, which must be adhered to within 60 days of publication. The other rules allow for 12-18 months, depending on the size of the fund. That may seem like a long time, but for new funds, it’s important to plan ahead to know which rules will apply and when the correct procedures need to be implemented.

What advisers should do now to comply with the new rules

The most important element to remember about these new rules is that they apply to funds differently based on size and fund activity. The reporting burden is going to be greater for funds of all sizes, but exactly what type of solutions you will need is going to vary and will depend on the specific fund.

The best option is a solution that offers the reporting, statements, and disclosure elements each fund needs without forcing advisers to pay for things that don’t apply for their funds. That’s why JTC’s fund administration solution is designed to be customizable, so you can get the elements you need when you need them and make the most efficient use of resources.

But before you can do that, you have to know which rules apply to you and what you have to do to comply with them (and when). You don’t want to get this wrong, so you want to work with partners who are up to date on the SEC’s procedures and best practices in the industry.

JTC works with funds of all sizes across many sectors, and can work with fund advisers to determine which solutions they need in order to work toward regulatory compliance. Our innovative client services model means our clients always know who to call with questions about regulatory issues. Don’t hesitate to reach out to a JTC representative to learn more about the SEC’s new rules, how they may affect your fund, and what JTC can do to make compliance easier.

To learn more about JTC’s customizable solutions for private funds, click here.

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