SEC Enhances the Regulation of Private Fund Advisers

Following a corresponding consultation in February 2022 (please see EventID 14399 in this context), the U.S. Securities and Exchange Commission has published a final version of its upcoming new rules under the Investment Advisers Act of 1940 which aim to enhance the protection of private funds investors.
#### Background
Last year the Commission launched noted consultation in which it proposed various amendments and additions to rules and regulations under the Investment Advisers Act of 1940 (17 CFR Part 275) to increase transparency, competition, and efficiency in the private funds market. The proposed amendments were manifold and ranged from additional disclosure requirements regarding fees and fund performances, to independent audit obligations, to the prohibition of certain activities altogether.
#### Feedback and final rules
The now published final version contains the feedback that the Commission has received to its consultation, subsequent changes the Commission has made to the draft version, and the final rules as they will be implemented following an extensive transition period.
(1) Feedback from the public
In detail, many commenters expressed concerns about potential negative effects on competition, especially for smaller and emerging advisers. They mentioned that restrictions on preferential treatment could hinder the ability of smaller advisers to secure initial investors, as smaller, emerging advisers often need to offer preferential rights to anchor investors. Additionally, increased compliance costs were seen as a potential barrier, which could lead to smaller advisers closing their funds and reducing the choices available to investors.
Some commenters also noted that the combined costs of multiple rulemakings could make it financially prohibitive for many advisers to stay in business or start a new one. This, in turn, could harm competition by creating new barriers to entry. Furthermore, there were concerns that the loss of smaller advisers would result in reduced diversity among investment advisers, particularly those owned by women and minorities, which could have downstream effects on entrepreneurial diversity.
As regards specific issues addressed in the proposed new provisions, there were mixed responses. For instance, many institutional investors found the annual financial statement audit requirement quite beneficial, while others argued that the stated policy objective of audits serving as a check on the adviser’s valuation of private fund assets will not be met.
Similar mixed feedback was received on the requirement to publish on a quarterly basis information on fund performance, fees, and expenses. Many respondents agreed with the requirement and argued that the proposed disclosures would bring about needed transparency. Others however, questioned that the SEC actually has the power to impose such requirements and that the disclosures would disproportionately increase compliance costs.
Finally, there was also mixed feedback on the proposed prohibition to provide preferential treatment to investors (without disclosing such treatment to other investors) and on the proposed new „Adviser-Led Secondaries Rule“ which would require a fund adviser to get an opinion of fairness when offering specific secondary investments / alternative investments to existing investors. Interestingly, as regards the proposed prohibition of preferential treatment, it was mainly investors that opposed to the proposed rule arguing that such prohibition would remove any option for them to take advantage of any „side arrangements“.
(2) Final rules and requirements
Taking into account the feedback from the public, the SEC has adjusted its final rules somewhat to ease regulatory burdens and, notably, to extend the transition period for compliance. The final rules as they will be implemented in a phased manner are as follows:
##### Rules applying specifically to private fund advisers who are registered with the Commission:
Quarterly investor statements: Private fund advisers registered with the SEC must now furnish investors with quarterly statements. These statements are required to contain comprehensive information concerning the performance of the private fund, as well as details regarding fees and expenses associated with the fund.
Annual audits: A significant change involves the obligation for private fund advisers to secure an annual audit (or upon liquidation) for each private fund under their management. The advisors will also have to distribute audited financial statements to private fund investors in alignment with the requirements of the audit provision of the custody rule (which the final rule will incorporate by reference). This audit requirement ensures transparency and accountability in the financial operations of these funds.
Fairness or valuation opinion: In connection with adviser-led secondary transactions, private fund advisers must obtain either a fairness opinion or a valuation opinion. This requirement is designed to safeguard the interests of investors during such transactions.
##### Rules affecting all private fund advisers:
Prohibition of certain activities: Advisers are required to refrain from engaging in specific activities and practices that could be detrimental to the public interest and the protection of investors. If they do engage in such activities, they must provide explicit disclosures to investors and, in some instances, obtain investor consent. Specifically, the rule prohibits advisers from:
– charging specific fees and expenses to a private fund, including expenses related to investigations by authorities, regulatory compliance costs, and fees related to portfolio investments on a non-pro rata basis when multiple private funds and other clients have invested in the same investment.
– reducing adviser clawback amounts due to taxes applicable to the adviser, its related persons, or their owners or interest holders, whether actual, potential, or hypothetical.
– borrowing money, securities, or other fund assets, or receiving loans or credit extensions from private fund clients.
Prevention of preferential treatment: The rules prohibit private fund advisers from providing certain forms of preferential treatment that could have a materially adverse impact on other investors. Any other types of preferential treatment must be disclosed to both current and prospective investors. Specifically, the rule prohibits private fund advisers from:
– granting investors the ability to redeem their interest in a way that may materially harm other investors, with exceptions for required redemptions by law and equal redemption opportunities for all investors.
– providing portfolio information that may materially harm other investors, with exceptions for simultaneous disclosure to all existing investors.
##### Rules extending to all registered advisers, including those not exclusively advising private funds:
All advisers are now obligated to maintain written documentation of their annual review of compliance policies and procedures.
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As this summary only contains the key provisions of the final rules, please refer to the original legal document for more detailed, comprehensive information.