By Robin L. Barton and Vincent Pitaro

Hedge Fund Law Report

On August 23, 2023, the SEC adopted final rules for private fund advisers (Rules), marking the biggest change in the industry since the Dodd‑Frank Act was passed in 2010. The five new Rules require advisers to provide quarterly fee, expense and performance reports; annual fund audits; fairness or valuation opinions in connection with adviser-led secondary transactions; disclosure and/or consent for certain “restricted activities”; and disclosures in connection with the preferential treatment of investors. The SEC also amended Rule 206(4)‑7 under the Investment Advisers Act of 1940 (Advisers Act), known as the “Compliance Rule,” to mandate written documentation of the adviser’s annual review of the effectiveness of its compliance program.

The SEC adopted the Rules over strong dissents from Commissioners Hester M. Peirce and Mark T. Uyeda, who, among other concerns, questioned the SEC’s authority to enact the Rules. This first article in a two-part series parses the Rules and how they differ from the SEC’s original proposal (Proposal). The second article will discuss the compliance challenges posed by the Rules and the next steps for CCOs. Future articles will dive into the details of each of the Rules, as well as what hedge fund managers need to do to comply with them.

See our three-part coverage of comments on the Proposal: “General Concerns” (Nov. 10, 2022); “Requests by Commenters” (Dec. 8, 2022); and “Concerns About Specific Requirements” (Jan. 19, 2023).

Statutory Basis for the Rules

According to the adopting release for the Rules (Release), from 2012 through 2022, investment advisers’ private fund assets under management (AUM) grew from $9.8 trillion to $26.6 trillion. Over the same period, the number of private funds more than tripled – from 31,717 to 100,947. “The industry has grown so much that the regulators are continually and increasingly interested in it – and one can only hope they don’t implement overly burdensome regulation,” commented Simpson Thacher partner Olga Gutman.

The SEC relied on Sections 206(4) and 211(h) of the Advisers Act as the “principal authority” for the Rules. Section 206(4) authorizes the SEC to adopt rules aimed at preventing fraudulent, deceptive or manipulative acts or practices. Section 211(h) directs the SEC to facilitate disclosures about the terms of adviser-investor relationships and promulgate rules to prohibit or restrict sales practices, conflicts of interest and compensation schemes that are contrary to the public interest or investor protection.

Although the SEC is particularly concerned about the indirect exposure of retail investors to private funds through their participation in pensions and other retirement plans, it took the position that Section 211(h) is not limited to protecting retail investors. For example, in his statement on the Rules, SEC Chair Gary Gensler cited the agency’s authority under the Dodd-Frank Act to “prohibit or restrict advisers’ sales practices, conflicts, and compensation schemes.” Thus, the SEC adopted the Rules “on behalf of all investors – big or small, institutional or retail, sophisticated or not,” he said. Commissioners Caroline A. Crenshaw and Jaime Lizárraga, who also voted to adopt the Rules, echoed Gensler’s concerns and arguments.

As in many other recent rulemakings affecting private funds, Commissioners Peirce and Uyeda voted against the Rules, raising concerns about:

• the abandonment of longstanding practices;
• interference with private negotiations between fund managers and investors;
• the impracticality of and confusion over some of the requirements; and
• the potential for harm to smaller advisers and barriers to entry for new advisers.

Most notably, however, both Peirce and Uyeda argued that the SEC lacked sufficient legal authority under the Dodd-Frank Act to adopt the Rules. They asserted that Section 211(h), which underlies many of the Rules, applies only to retail investors.

That argument is echoed in a petition (Petition) filed by a coalition of private fund industry organizations on September 1, 2023, seeking judicial review of the Rules. The Petition asserts the Rules are fundamentally overbroad, beyond the scope of the SEC’s statutory authority and in violation of various statutory requirements. Although it is too early to determine the Petition’s impact, it is important to note that the filing of the Petition does not toll the compliance deadlines for the Rules.

See “Proposed Private Fund Rules: Overview of the Proposal and the Importance of Industry Comments” (Mar. 17, 2022); as well as our two-part series on the Proposal: “General Observations” (Apr. 7, 2022); and “Rule‑Specific Concerns and Next Steps” (Apr. 14, 2022).

Applicability of Rules

Types of Advisers

The quarterly statement, audit and adviser-led secondaries Rules will apply to all SEC-registered investment advisers. They will not apply with respect to non‑U.S. private funds of an SEC-registered offshore adviser, even if the funds have U.S. investors.

The Rules on restricted activities and preferential treatment will apply to all advisers to private funds, regardless of their registration status. They do not, however, apply to offshore unregistered advisers with respect to their offshore funds, even if those funds have U.S. investors.

Finally, the amendment to the Compliance Rule will require all registered advisers – including those that do not advise private funds – to document in writing their annual review of their compliance programs.

Types of Funds

None of the five Rules will apply to any securitized asset funds (SAFs), which are defined in the Rules as “any private fund whose primary purpose is to issue asset backed securities and whose investors are primarily debt holders.”

The Rules discuss private funds in terms of “illiquid funds” and “liquid funds.” An illiquid fund is not required to redeem investor interests on request and offers limited or no opportunities to withdraw before the fund’s termination. Any fund that is not an illiquid fund is a liquid fund. Thus, most hedge funds will be categorized as liquid funds, although hybrid funds may be more challenging to label.

The Rules can be broken down into five new rules, which are discussed in detail below.

1) Quarterly Statement Rule

Private fund disclosures about performance, fees and expenses are often neither simple nor clear, the Release stresses. New Rule 211(h)(1)‑2 requires an adviser to prepare and distribute to investors a quarterly statement that complies with the requirements of the Rule for any private fund, other than an SAF, that has at least two full fiscal quarters of operating results.

Fee, expense and performance information are all “essential component[s] of the basic set of information that is generally necessary for private fund investors to evaluate accurately and confidently their private fund investments,” the SEC posited. Consequently, there are no exemptions for small or emerging advisers, and the requirement cannot be waived.

See “Preparing for Compliance With SEC’s Proposed Private Funds and Cybersecurity Rules” (Aug. 18, 2022); and “Quarterly Reporting Requirements and Prescriptive Prohibited Activities in the SEC’s Proposed Amendments to the Advisers Act (Part Two of Two)” (Apr. 28, 2022).

Formatting and Information

The quarterly statement must be written in “clear, concise, plain English [and] presented in a format that facilitates review from one quarterly statement to the next,” the Rule states. An adviser may include information in the statement in addition to what is required by the Rule. However, such additional information must:

• be as short as practicable;
• be no more prominent than the required information; and
• not obscure or impede an investor’s understanding of the mandatory information.

All fee, expense and portfolio investment compensation information must be presented both before and after the application of any offsets, rebates or waivers. Both tables discussed below must include “prominent disclosure” regarding the manner in which expenses, allocations, rebates, waivers and offsets are calculated, as well as cross-references to the sections of the fund’s offering documents that describe the relevant calculation methodology.

The SEC adopted a principles-based approach to consolidated reporting to accommodate the diversity of the private funds industry. Thus, an adviser must consolidate reporting of “similar pools of assets” managed by the adviser or its related persons to the extent it would provide more meaningful information to investors and not be misleading. The Rules define “similar pool of assets” to include a pooled investment vehicle – other than a registered investment company or SAF – with “substantially similar investment policies, objectives or strategies” to the fund in question.

Statement Contents

The quarterly statement must disclose:

• the value and date of each of the fund’s capital inflows and capital outflows since inception; and
• the fund’s net asset value as of the end of the reporting period.

The statement must also include a table showing fund-level information and a separate table showing information at the portfolio investment level. In addition, the statement must provide specified performance information.

Fund Information Table

The fund information table must include:

• a detailed accounting of all compensation, fees and other amounts paid to the adviser or its related persons during the accounting period, with a separate line item showing each category of payment, including, without limitation, performance-based compensation, as well as management, advisory, sub-advisory and similar fees, along with the total dollar amount for each category;
• a detailed accounting of all other fees or expenses allocated to or paid by the fund, with separate categories that include, but are not limited to, organizational, accounting, legal, administration, audit, tax, due diligence and travel; and
• the amount of any offsets or rebates carried forward during the reporting period to future periods that will reduce payments or allocations to the adviser or its related persons.

For purposes of the Rules, “related persons” include the adviser’s officers, partners, directors and current employees (other than those in purely clerical, administrative or similar roles), as well as persons directly or indirectly controlling, controlled by or under common control with the adviser. That treatment is consistent with treatment under Form ADV and Form PF, the SEC explained.

The Rule defines “performance-based compensation” to include “allocations, payments, or distributions of capital based on [a] private fund’s (or its investments’) capital gains, capital appreciation and/or other profit.” There are no de minimis exceptions. Advisers may not group expenses into broad categories or label expenses as “miscellaneous.” The final Rule clarifies that the table must cover both expenses “paid by” and those “allocated to” the private fund.

See “OCIE Risk Alert Warns of Six Most Frequent Fee and Expense Compliance Issues” (May 3, 2018).

Portfolio Investment Table

The portfolio investment table must include a detailed accounting of all “portfolio investment compensation” allocated or paid to the adviser or a related person by each portfolio investment during the reporting period, with a separate line item for each category of compensation and the total amount paid.

“Portfolio investment compensation” includes fees or other amounts paid to the adviser or a related person that are attributable to the fund’s investment in a portfolio company:

• Included: fees or compensation for management, consulting, monitoring, administration, advisory, trustee or director services; and
• Excluded: dividend payments, profit distributions, returns of capital or similar payments from a portfolio investment to the fund.

For purposes of this Rule, a portfolio investment includes any entity in which the fund holds an interest, whether directly or indirectly. According to the Release, the portfolio investment table should generally disclose “the identity of each covered portfolio investment to the extent necessary for an investor to understand the nature of the potential or actual conflicts associated with such payments” but does not have to specify the fund’s ownership percentage in the portfolio investment.

See “SEC Continues to Scrutinize Accelerated Private Equity Monitoring Fees” (Aug. 23, 2018).

Performance Information

The performance information that an adviser must present depends on whether the private fund is an illiquid fund or a liquid fund. A liquid fund’s quarterly statement must show:

• annual net total returns for each of the past ten years or, if shorter, from inception;
• average annual net total returns over the most recent one‑, five‑ and ten‑fiscal-year periods; and
• cumulative net total return for the current fiscal year as of the end of the most recent fiscal quarter.

The Rule does not define “net total return.” As with the fee/expense and portfolio investment tables, the performance statement must include “prominent disclosure” of the criteria used, and assumptions made, in calculating performance. The interests of the adviser and its affiliates in the fund generally should be excluded from the performance calculations “to prevent the performance from being misleading,” which could occur because those interests do not pay management or performance fees, the Release cautions.

See “Parsing the Significance of the SEC’s FAQ on the Presentation of Gross and Net Performance” (Mar. 2, 2023).

Delivery

The Proposal would have required all quarterly statements to be delivered within 45 days of the end of the relevant quarter. As adopted, for a private fund that is not a fund-of-funds, the statement must be delivered within 45 days of the end of each of its first three fiscal quarters of the fund’s fiscal year and within 90 days of the end of its fiscal year. The statement for a fund-of-funds must be delivered within 75 days of the end of its first three fiscal quarters and within 120 days of the end of its fiscal year.

The statement must be delivered to all investors in a private fund. If the investor is a pooled vehicle that controls, is controlled by or is under common control with the adviser or its related persons, the adviser must look through the pooled vehicle and distribute the statement to the investors in the pooled vehicle.

2) Mandatory Fund Audit Rule

The SEC adopted the mandatory fund audit rule largely as proposed but with several changes to bring it more closely in line with the requirements of Rule 206(4)‑2 under the Advisers Act, known as the “Custody Rule,” on which it is based. Thus, under new Rule 206(4)‑10, an adviser registered or required to be registered with the SEC must cause each of its private funds, other than SAFs, to undergo a financial statement audit that meets the requirements of the Custody Rule, effectively eliminating the Custody Rule’s surprise examination option.

For delivery of the audit results, the adviser must look through any investor that is a pooled vehicle to the investor’s underlying owners. The final Rule adopted the Custody Rule’s 120‑day delivery period instead of the proposed requirement to deliver them “promptly.”

The SEC did not include its proposed requirement that an auditor notify the SEC in the event the auditor issued a modified opinion, resigned, was dismissed or otherwise terminated its engagement.

See our two-part discussion of the Custody Rule with Proskauer partner Robert Plaze: “History and Possible Amendments” (Dec. 19, 2019); and “Compliance Challenges, Common Issues and Tips” (Jan. 16, 2020).

3) Adviser‑Led Secondaries Rule

The Rules define “adviser-led secondary transaction” (secondary) as a transaction initiated by a private fund adviser or its related persons that gives investors the choice between:

• selling all or a portion of the investor’s interest in the fund; and
• converting or exchanging all or a portion of that interest into an interest in another fund advised by the adviser or a related person.

The SEC will consider an adviser to have “initiated” a secondary if the adviser “commences a process, or causes one or more other persons to commence a process” designed to offer liquidity to fund investors, including single asset transactions, strip sale transactions and full fund restructurings, according to the Release. It does not encompass, however, rebalancing between parallel funds or so-called “season and sell” transactions.

In a change from the Proposal, the final Rule permits an adviser conducting a secondary to obtain a valuation opinion in lieu of a fairness opinion. The opinion provider must provide such opinions in the ordinary course of its business and must not be a related person of the adviser. In another change from the Proposal, the opinion and summary must be distributed to investors before the due date of the investor’s election form for the secondary rather than before the closing of the transaction.

See “Key Structuring and Negotiating Points in Secondary Sales of Private Fund Interests” (Mar. 21, 2014).

4) Restricted Activities Rule

The final version of Rule 211(h)(2)‑1 covers five categories of activities, three of which have disclosure-based exceptions and two of which have exceptions that require disclosure and investor consent. That is a change from the Proposal, which sought to prohibit those same categories, as well as two others. The SEC acknowledged that the proposed outright prohibitions may have resulted in “unfavorable outcomes for investors” in certain situations.

Restricted Activities With Disclosure-Based Exceptions

Pursuant to this Rule, an adviser may not:

1. charge or allocate any regulatory fees, compliance fees or examination-related expenses or costs to a private fund unless the adviser distributes to investors a written notice describing the charges, including the dollar amount, within 45 days of the end of the fiscal quarter in which the charges occur;
2. reduce the amount of an adviser clawback by any actual or hypothetical taxes payable by the adviser, its related persons or their respective owners/interest holders unless the adviser distributes to investors written notice of the total amount of the clawback, both before and after any reduction for taxes, within 45 days of the end of the fiscal quarter in which the clawback occurs; or
3. when multiple private funds and/or clients advised by the adviser have invested in the same portfolio investment, allocate fees or expenses related to that investment on a non-pro rata basis unless:
   • the allocation is “fair and equitable under the circumstances”; and
   • before making the allocation, the adviser distributes written notice to investors of the allocation and an explanation of why it is fair and equitable.

To be fair and equitable, an allocation does not have to treat all investors identically, the Release notes. Whether the allocation is fair and equitable will depend on factors relevant to the expense in question.

See “Best Practices for Hedge Fund Managers to Mitigate the Conflicts Arising From Managed Accounts: Dealing With Trade and Expense Allocations (Part Three of Three)” (Aug. 1, 2019); and “SEC Fines Fund Manager for Failing to Equitably Allocate Fees and Expenses to Its Affiliate Funds and Co‑Investors” (Jun. 6, 2019).

Restricted Activities With Consent-Based Exceptions

An adviser may not:

1. charge or allocate fees or expenses associated with regulatory investigations of the adviser or its related persons unless the adviser seeks consent from all investors and obtains written consent from at least a majority of investors that are not related persons of the adviser; or
2. borrow money, securities or other assets, or obtain a loan or extension of credit, from a private fund unless the adviser:
   • distributes to each investor a written description of the material terms of the proposed transaction with a request for consent; and
   • obtains written consent from at least a majority of investors that are not related persons of the adviser.

An adviser may never, however, charge or allocate any fees or expenses in connection with an investigation that results in the adviser being sanctioned for violating the Advisers Act or the rules thereunder. If an investigation for which an adviser has already allocated fees or expenses to a fund results in a sanction, the adviser must reimburse the fund, the Release notes.

See “How Managers Can Navigate the Thin Line Between SEC Examinations and Enforcement” (Nov. 14, 2019).

Rule Does Not Address Waivers of Fiduciary Obligations

The final Rule does not address efforts by an adviser to seek reimbursement, indemnification, exculpation or limitation of liability by a fund or its investors for a breach of fiduciary duty, willful misfeasance, bad faith, negligence or recklessness in providing services to the fund. Although the SEC still considers such practices to be “problematic,” it decided the proposed prohibition was not needed in light of the existing antifraud provisions of the Advisers Act and the SEC’s interpretation of an adviser’s fiduciary duties.

Michael Koffler, partner at Eversheds Sutherland, described the elimination of that provision from the Proposal as “probably the best example of the Commission’s responding to comments but also having an eye toward the prospect of litigation.”

See our three-part series on navigating the SEC’s interpretation of advisers’ fiduciary duty: “What It Means to Be a Fiduciary” (Oct. 17, 2019); “Six Tools to Systematically Identify Conflicts of Interest” (Oct. 24, 2019); and “Three Tools to Systematically Monitor Conflicts of Interest” (Nov. 7, 2019).

5) Preferential Treatment Rule

Preferential Redemption Rights

An adviser to a private fund other than an SAF may not, directly or indirectly, grant preferential redemption rights to an investor that the adviser “reasonably expects to have a material, negative effect on other investors in that private fund or in a similar pool of assets,” unless:

• the redemption right is required by applicable law or regulation; or
• the adviser has offered the same redemption rights to all other investors and will continue to offer them to future investors.

To qualify for the second exemption, the redemption rights must be offered to other investors “without qualification,” the Release notes. Thus, they cannot be limited by commitment size, affiliation with the adviser or other criteria.

See “Study Finds Fee Discounts and MFN Provisions Still Common in Side Letters” (Jan. 19, 2023).

Preferential Information Rights

Similarly, an adviser may not provide information about the holdings or exposures of a private fund or a similar pool of assets to any fund investor if the adviser reasonably expects that providing the information would have a material, negative effect on other investors in the fund or in a similar pool of assets – unless the adviser offers the information to all investors in the fund and any similar pool of assets at the same time or substantially the same time.

See our two-part series on side letters: “Complications of Using Standard Form Provisions and Managing Administrative Burdens” (Sep. 9, 2021); and “Trends in Hot‑Button Terms in Side Letter Negotiations” (Sep. 16, 2021).

Other Preferential Rights

An adviser may not provide any preferential treatment – including preferential redemption or information rights – to any private fund investor unless the adviser:

• provides to each prospective investor, before the investor’s investment in the fund, written notice of any preferential treatment related to any material economic terms;
• distributes to each current investor written disclosure of all preferential treatment provided to investors as soon as reasonably practicable:
  • after the end of an illiquid fund’s fundraising period; or
  • after an investor’s investment in a liquid fund; and
• provides, at least annually, written notice to investors of any new preferential treatment provided since the adviser’s last notice.

See our three-part series on managing side letters: “Importance of Effective Negotiation” (Nov. 19, 2020); “Assigning Responsibility and Effective Documentation” (Dec. 3, 2020); and “Tracking Triggers, Testing and Addressing MFN Provisions” (Dec. 17, 2020).

Differences from Proposed Preferential Treatment Rule

Compared to the Proposal, the final Rule:

• includes exceptions to the prohibitions on granting preferential redemption or information rights;
• applies the disclosure obligations to all preferential treatment – not just preferential treatment other than preferential redemption or information rights;
• only requires the adviser to provide advance notice to prospective investors of preferential rights affecting material economic terms; and
• fine-tunes the delivery requirements pertaining to disclosures to existing investors.

Other Key Elements of the Rules

Change to the Compliance Rule

The final amendment to Rule 206(4)‑7(b) requires an adviser to “review and document in writing, no less frequently than annually, the adequacy of the policies and procedures established pursuant to this section and the effectiveness of their implementation” (emphasis supplied). The SEC did not prescribe the form or content of that documentation, however.

See “Risk Alert on Compliance: Inadequate Annual Reviews, Poorly Implemented Policies and Other Key Takeaways (Part Two of Two)” (Feb. 25, 2021); as well as our two-part series “A Checklist for Investment Advisers to Streamline and Organize Their Annual Compliance Program Reviews”: Part One (Dec. 13, 2018); and Part Two (Dec. 20, 2018).

Recordkeeping Provisions

Each of the Rules has associated recordkeeping requirements. All of those requirements are included in a conforming amendment to Rule 204‑2(a)(7) under the Advisers Act (the Books and Records Rule). Throughout the Rules, the SEC eliminated its proposed requirement that the records include both the address of each recipient and the delivery method.

See our two-part roadmap to maintaining books and records: “Compliance With Applicable Regulations” (Nov. 2, 2017); and “Document Retention and SEC Expectations” (Nov. 9, 2017).

Legacy Provision

The provisions of the Rules governing investigation-related expenses and borrowing, as well as the restrictions on preferential redemption and information rights, will not apply to “contractual agreements” governing a fund that has commenced operations on the Rule’s compliance date and that were entered into in writing before the compliance date, if the Rule would otherwise have required amending those agreements. The Release specifies that commencement of fund operations can be evidenced, among other ways, by:

• setting up a subscription facility;
• holding an initial closing;
• conducting investment due diligence; or
• making an investment.

In contrast, there is no grandfathering of the Rules’ disclosure obligations. Consequently, “information in side letters that existed before the compliance date will be disclosed to other investors that invest in the fund post compliance date,” the Release cautions.

The attorneys the Hedge Fund Law Report spoke to agreed that the legacy provision was essential, with Troutman Pepper partner Genna Garver calling it “mission critical.” Daniel Bresler, partner at Seward & Kissel, noted, “Without it, the Rules are, in some ways, unworkable.” Gutman added, “It’s hugely important for managers that are managing current funds. They don’t need to go back and reopen the terms and procedures for the grandfathered fund because anytime you do that, there’s a whole new dynamic within the fund.”

“When you change the rules of the road so dramatically, you have to recognize that the contractual provisions in place were the result of reasonable expectations of parties on both sides based on decades of experience and a different set of rules,” Koffler explained. “To negate those provisions could have resulted in litigation from investors that would have taken years to unwind. It literally would have opened up Pandora’s box – and could have brought certain funds to a standstill. So, practically speaking, I’m not sure there really was much of a choice.”

Compliance Deadlines

The Rules and the amendments to the Compliance Rule will take effect 60 days after publication in the Federal Register, which occurred on September 14, 2023. Thus, the Rules will take effect on November 13, 2023. Advisers will be required to comply with the amended Compliance Rule as of that date.

As for compliance with the five new Rules, the SEC adopted an 18‑month transition period for the Rules requiring the delivery of quarterly statements and annual audits; therefore, the compliance deadline for those rules is March 14, 2025. The Rules addressing adviser-led secondaries, restricted activities and preferential treatment have the following transition periods:

• 12 months for advisers with $1.5 billion or more in private fund AUM (compliance deadline: September 14, 2024); and
• 18 months for smaller advisers (compliance deadline: March 14, 2025).