Fresh on the heels of a recent proposal regarding amendments to Form PF[1]and published observations from examinations of private fund advisers,[2] the SEC voted on February 9, 2022 to propose new rules under the Investment Advisers Act of 1940 (the Advisers Act) that, if implemented, would have profound effects on the private equity industry and the relationship among the SEC, sponsors and investors.[3] The proposal marks a meaningful departure from the SEC’s traditional focus on private fund disclosure to a more prescriptive, rules-based regime that would:

  • regardless of disclosure or investor consent, prohibit all advisers to private funds,[4] including those not registered with the SEC (such as exempt reporting advisers), from engaging in the following practices that the SEC deems “contrary to the public interest”:
    • charging a portfolio investment accelerated or other fees for which the adviser does not actually provide services;
    • charging a fund for fees or expenses associated with a regulatory examination or investigation of the adviser or other compliance activities;
    • reducing the amount of any adviser clawback by taxes applicable to the adviser, its related persons or their respective owners or interest holders;
    • seeking reimbursement, indemnification, exculpation or limitation of its liability by the fund or its investors for a breach of fiduciary duty, willful misfeasance, bad faith, negligence or recklessness in providing services to the fund;
    • charging or allocating fees and expenses related to a portfolio investment on a non-pro rata basis; and
    • borrowing from a fund client.
  • prohibit all private fund advisers, including those not registered with the SEC (such as exempt reporting advisers), from providing preferential treatment to certain fund investors regarding redemptions or information about portfolio holdings or exposures and, unless the adviser discloses such treatment to current and prospective investors, all other types of preferential treatment;
  • impose new quarterly reporting requirements on registered private fund advisers requiring disclosure to investors of fund performance, fees and expenses and manager compensation;
  • require registered private fund advisers to obtain a fairness opinion in connection with any adviser-led secondary transactions;
  • require registered private fund advisers to obtain an annual financial statement audit of each managed fund;
  • amend the Advisers Act books and records rule to require registered advisers to retain books and records to facilitate compliance with the new rules; and
  • amend the Advisers Act compliance rule (Rule 206(4)-7) to require all registered advisers, including those that do not manage private funds, to document in writing the annual review of their compliance policies and procedures.

Prohibited Activities

The proposal would prohibit all private fund advisers, including those that are not registered with the SEC (such as exempt reporting advisers),[5] from engaging in certain activities (regardless of whether the activities are disclosed, the fund’s constituent documents would otherwise allow them or investors previously provided consent) including:

  • charging a portfolio investment for monitoring, servicing, consulting or other fees in respect of any services that the investment adviser does not, or does not reasonably expect to, provide to the portfolio investment (e.g., accelerated fees);[6]
  • charging the private fund for fees or expenses associated with an examination or investigation of the adviser or its related persons by any governmental or regulatory authority, regardless of whether any wrongdoing has occurred;
  • charging the private fund for any regulatory or compliance fees or expenses of the adviser or its related persons;
  • reducing the amount of any adviser clawback[7] by actual, potential or hypothetical taxes applicable to the adviser, its related persons or their respective owners or interest holders;
  • seeking reimbursement, indemnification, exculpation or limitation of its liability by the private fund or its investors for a breach of fiduciary duty, willful misfeasance, bad faith, negligence or recklessness in providing services to the private fund;
  • charging or allocating fees and expenses related to a portfolio investment (or potential portfolio investment) on a non-pro rata basis when multiple private funds and other clients advised by the adviser or its related persons have invested (or propose to invest) in the same portfolio investment;[8] and
  • borrowing money, securities or other private fund assets, or receiving a loan or an extension of credit, from a private fund client.

Notably, many of the aforementioned prohibited activities are inconsistent with express terms in underlying private equity fund agreements that have been commonplace for years.

Preferential Treatment

Illustrating the SEC’s discomfort with certain side letter provisions, all private fund advisers, including those not registered with the SEC (such as exempt reporting advisers), would be prohibited under the proposal from:

  • granting an investor in the private fund or in a substantially similar pool of assets the ability to redeem its interest on terms that the adviser reasonably expects to have a material, negative effect[9] on other investors in that private fund or in a substantially similar pool of assets; or
  • providing information regarding the portfolio holdings or exposures of the private fund, or of a substantially similar pool of assets, to any investor if the adviser reasonably expects that providing the information would have a material, negative effect on other investors in that private fund or in a substantially similar pool of assets.[10]

Additionally, all private fund advisers, including those not registered with the SEC (such as exempt reporting advisers), would be prohibited under the proposal from providing other preferential treatment[11] to any investor in a private fund unless the adviser provides specific information regarding such preferential treatment (i) in advance to prospective fund investors and (ii) annually to current fund investors for any new preferential terms.[12] This required disclosure and attendant logistical challenges could have significant impacts on the mechanics and timing of fund closings.

Quarterly Reporting Requirements

The proposal would require private fund advisers that are registered with the SEC to prepare standardized quarterly statements that include information regarding fund performance, fees and expenses and manager compensation.[13] Such statements would be distributed to the private fund’s investors within 45 days after each calendar quarter end, should consolidate reporting for substantially similar pools of assets (such as parallel and alternative investment vehicles) to the extent doing so would provide more meaningful information to the private fund’s investors and would not be misleading and must include the following information:

Fees and Expenses. In a tabular format, private fund advisers would need to disclose certain fund-level fees and expenses, including:

  • all compensation, fees and other amounts allocated or paid to the adviser or any of its related persons (in separate line items) by the private fund during the reporting period (e.g.,management, advisory, sub-advisory, administrative or similar fees or payments and performance-based compensation paid to the private fund adviser (or any of its related persons) by the fund);
  • an itemized accounting of all other fund fees and expenses (e.g.,organizational, accounting, legal, administration, audit, tax, due diligence and travel expenses) paid during the reporting period; and
  • the amounts of any offsets, rebates or waivers carried forward during the reporting period to subsequent quarterly periods to reduce future payments or allocations to advisers or their related persons.

The proposal requires advisers to disclose adviser compensation and fund expenses in the table both before and after the application of offsets, rebates and waivers.

Portfolio Investment-Level Disclosure. In a tabular format, private fund advisers would need to disclose certain information (in a single table but broken down by investment) regarding “covered portfolio investments,”[14] including:

  • a detailed accounting of compensation allocated or paid by covered portfolio investments (both before and after any offsets, rebates or waivers) to the adviser or its related persons during the reporting period (e.g., origination, management, consulting, monitoring, servicing, transaction, administrative, advisory, closing, disposition, directors, trustees or similar fees or payments) that is attributable to the private fund’s interest in the covered portfolio investment;[15] and
  • the private fund’s ownership percentage of each covered portfolio investment as of the reporting period’s end.[16]

Calculation Methodologies and Cross References to Organizational and Offering Documents. The proposal would require private funds’ quarterly statements to contain prominent disclosure regarding calculation methodologies for expenses, payments, allocations, rebates, waivers and offsets as well as cross references to the specific sections of the relevant private fund organizational and offering documents containing such methodologies.

Performance Disclosure. Under the proposal, private funds would need to include standardized fund performance information in their quarterly statements. The specifics of such information would be dependent on fund type. Advisers to illiquid funds (which include typical private equity funds)[17] would be required to show:

  • internal rate of return (IRR) and multiple of invested capital (MOIC) on both a gross and net basis;[18]
  • gross IRR and gross MOIC for the realized and unrealized portions of the illiquid fund’s portfolio, with the realized and unrealized performance shown separately; and
  • a statement of contributions and distributions.[19]

The performance must be shown since inception through the end of the applicable quarterly period (or the most recent practicable date) and the quarterly statement must include prominent disclosure of the criteria used and assumptions made in calculating the performance. Illiquid fund performance must be calculated without the impact of fund-level subscription facilities.[20] An adviser would be permitted to include other performance metrics in the quarterly statement as long as the quarterly statement presents the performance metrics prescribed by the proposed rule and complies with the other requirements in the proposed rule.

Advisers to liquid funds[21] would disclose performance based on net total return (i) on an annual basis since the fund’s inception; (ii) on a current year-to-date basis as of the end of the most recent calendar quarter; and (iii) over one-, five- and ten-year periods, as applicable.

Adviser-Led Secondary Transactions

Under the proposal, registered private fund advisers would be required to obtain a fairness opinion[22]from an independent opinion provider[23] in connection with adviser-led secondary transactions where an adviser offers fund investors the option to sell their interests in the private fund or to exchange them for new interests in another vehicle advised by the adviser. Additionally, a summary of any material business relationships[24] between the adviser or its related persons and the independent opinion provider during the previous two years would need to be distributed to investors prior to the closing of the transaction.

Private Fund Audits

Under the proposal, registered private fund advisers would be required to obtain an annual audit (and an audit upon liquidation) in accordance with U.S. GAAP of the financial statements of all managed funds by an independent public accountant registered with the Public Company Accounting Oversight Board.[25] Upon completion of the audit, audited financial statements would need to be distributed promptly to current investors. Additionally, the independent public accountant responsible for auditing a fund’s financial statements would be required (pursuant to a written agreement with the adviser) to notify the SEC (i) promptly upon issuing a report containing a modified opinion and (ii) within four business days of resignation or dismissal from, or other termination of, the engagement or upon removing itself or being removed from consideration for being reappointed as fund auditor. With respect to sub-advisers that do not control private funds, the proposal requires such advisers to take all reasonable steps to cause sub-advised clients to undergo an audit that would satisfy the new rule’s requirements.

An audit conducted pursuant to the “audit exception” in the Advisers Act custody rule (Rule 206(4)-2) would generally satisfy this new audit requirement. However, funds that choose to undergo a surprise examination of their assets under the custody rule would still need to undergo an audit in accordance with the proposal. In addition, unlike the custody rule, the proposal requires a written agreement between the adviser of the private fund and the auditor pursuant to which the auditor would be required to notify the SEC upon the auditor’s termination or issuance of a modified opinion.

Notable Requests for Comment

The SEC’s proposing release contains dozens of requests for comments on aspects of the rule proposals, some of which could have further drastic impacts on the private equity industry. For example, the SEC solicited input on whether it should:

  • establish maximum fees that advisers may charge at the fund level;
  • prohibit certain compensation arrangements, such as the “2 and 20” model;
  • prohibit advisers from receiving compensation from portfolio investments to the extent they also receive management fees from the fund;
  • require advisers to disclose their anticipated management fee revenue and operating budget to private fund investors;
  • impose limitations on management fees (which are typically paid regardless of whether the fund generates a profit) but not impose limitations on performance-based compensation (which is typically tied to the success of the fund);
  • prohibit management fees from being charged as a percentage of committed capital and instead only permit management fees to be based on invested capital, net asset value and other similar types of fee bases;
  • prohibit certain expense practices or arrangements, such as expense caps provided to certain, but not all, investors;
  • prohibit additional types of fees or expenses from being charged to a private fund;
  • require disclosure of portfolio company compensation paid to other persons (such as co-investors, joint venture partners and other third parties) to the extent such compensation reduces the value of the private fund’s interest in the applicable portfolio investment;
  • prohibit deal-by-deal (or “American”) distribution waterfalls;
  • require fairness opinions in respect of certain other transactions;
  • prohibit contractual provisions that limit or purport to waive fiduciary duties and other liabilities in situations where state law permits such waivers;
  • prohibit the practice of having one fund entity contract with a transaction counterparty on behalf of a group of fund entities and instead require each fund entity to contract directly with such counterparty;
  • restrict the use of side letters and side arrangements so that they can only be used to address certain matters such as, for example, legal, regulatory or tax issues that are specific to an investor;
  • exclude certain activity from the prohibition on fund lending (e.g., scenarios where a fund makes tax advances or tax distributions to its general partner to ensure that the general partner and its investment professionals are able to pay their personal taxes derived from the general partner’s interest in the fund); and
  • prohibit all preferential treatment.

Comment and Transition Periods: Absence of Grandfathering

Comments on these proposals are due on or before 30 days after publication of the proposals in the Federal Register or April 11, 2022, whichever is later. The SEC proposed a one-year transition period to provide time for advisers to come into compliance with these new rules (if they are adopted). Therefore, the compliance date for the new rules would be one year following the rules’ effective dates.

Importantly, the proposals do not contain any “grandfathering” provisions for existing fund agreements and side letters. Therefore, if the rules are adopted as proposed, sponsors would have to undertake a burdensome process to review all fund documents and determine how best to proceed in order to ensure compliance with the new requirements.

Endnotes    (↵ returns to text)
  1. A previous alert discussing the SEC’s proposed amendments to Form PF can be found here.
  2. A previous alert discussing the SEC’s observations from recent examinations of private fund advisers can be found here.
  3. The SEC’s proposing release can be found here.
  4. The proposal generally only applies to funds relying on the exceptions from the definition of “investment company” contained in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 (the 1940 Act). The SEC requested comments on whether the rules should apply to other types of private funds (such as real estate funds relying on Section 3(c)(5)(C) of the 1940 Act or certain securitization vehicles relying on Rule 3a-7 under the 1940 Act).
  5. The SEC noted that it has historically taken the position that most of the substantive provisions of the Advisers Act do not apply with respect to the non-U.S. clients (including funds) of a registered offshore adviser. Therefore, the proposed prohibited activities rule would not apply to a registered offshore adviser’s private funds organized outside of the United States, regardless of whether the private funds have U.S. investors. The SEC solicited comments on the applicability of all the proposed rules to registered offshore advisers’ non-U.S. clients.
  6. The SEC suggested that private funds would be in compliance with this rule if (i) any such fees were subject to a 100% management fee offset and (ii) to the extent of any excess fees where no further offset can be applied, the adviser offered investors a rebate or another economic benefit equal to their pro rata share of any such excess fees.
  7. An “adviser clawback” is defined as any obligation of the adviser, its related persons or their respective owners or interest holders to restore or otherwise return performance-based compensation to the private fund pursuant to the private fund’s governing agreements.
  8. The SEC clarified that to the extent a potential co-investor has not executed a binding agreement to participate in the transaction through a co-investment vehicle (or another fund) managed by the adviser, the proposed rule would not prohibit the adviser from allocating “broken-deal” or other fees and expenses attributable to such potential co-investor to a fund that would have participated in the transaction. However, the SEC also reminded advisers that they may be liable under the antifraud provisions of the Federal securities laws if the fund’s offering and organizational documents do not authorize such costs to be charged to the fund.
  9. As an example of a potential material negative effect, the SEC discussed a situation where an adviser sells liquid assets to accommodate a preferred investor’s redemption, leaving the fund with a less liquid pool of assets, which can inhibit the fund’s ability to carry out its investment strategy or promptly satisfy other investors’ redemption requests.
  10. The SEC stated that selective disclosure of portfolio holdings or exposures can result in profits or avoidance of losses among those who were privy to the information beforehand at the expense of investors who did not benefit from such transparency. In addition, such information could enable an investor to trade in portfolio holdings in a way that “front-runs” or otherwise disadvantages the fund or other clients of the adviser.
  11. The SEC noted that whether any terms are “preferential” would depend on all of the surrounding facts and circumstances.
  12. As an example, the SEC stated that if an adviser provides an investor with lower fee terms in exchange for a significantly higher capital contribution than paid by others, it does not believe that mere disclosure that some investors pay a lower fee is specific enough. Instead, the adviser must describe the lower fee terms, including the applicable rate (or range of rates if multiple investors pay such lower fees), in order to provide specific information as required by the proposed rule. An adviser could comply with the proposed disclosure requirements by providing copies of side letters (with identifying information regarding the other investors redacted). Alternatively, an adviser could provide a written summary of the preferential terms provided to other investors in the same private fund, provided the summary specifically describes the preferential treatment.
  13. The proposed rule requires fund-level rather than individualized reporting, although the SEC requested comment on whether personalized information based on an investor’s individual stake in the fund should be required. The SEC also requested comment on whether to prohibit certain types of performance information in the quarterly statement, including performance that includes the impact of fund-level subscription facilities.
  14. The proposal defines “covered portfolio investment” as any entity or issuer in which the private fund has invested directly or indirectly that allocated or paid the adviser or its related persons compensation during the reporting period.
  15. Such amount would not reflect the portion attributable to any other person’s (such as a co-investor’s) interest in the covered portfolio investment.
  16. If the fund does not have an ownership interest in the covered portfolio investment (e.g., if the fund owns debt of the portfolio investment), the adviser would be required to list zero percent as the fund’s ownership percentage along with a brief description of the fund’s investment in such covered portfolio investment.
  17. The proposal defines an “illiquid fund” as a private fund that: (i) has a limited life; (ii) does not continuously raise capital; (iii) is not required to redeem interests upon an investor’s request; (iv) has as a predominant operating strategy the return of the proceeds from disposition of investments to investors; (v) has limited opportunities, if any, for investors to withdraw before termination of the fund; and (vi) does not routinely acquire (directly or indirectly) as part of its investment strategy market-traded securities and derivative instruments.
  18. The proposal defines IRR as the discount rate that causes the net present value of all cash flows throughout the life of the fund to be equal to zero and MOIC as (i) the sum of: (A) the unrealized value of the illiquid fund; and (B) the value of all distributions made by the illiquid fund; (ii) divided by the total capital contributed to the illiquid fund by its investors, as of the end of the applicable calendar quarter. The SEC requested comment on whether to modify these definitions.
  19. This would consist of (i) all capital inflows the private fund has received from investors and all capital outflows the private fund has distributed to investors since the private fund’s inception, with the value and date of each inflow and outflow and (ii) the net asset value of the private fund as of the end of the reporting period.
  20. These are defined as any subscription facilities, subscription line financing, capital call facilities, capital commitment facilities, bridge lines or other indebtedness incurred by the private fund that is secured by the unfunded capital commitments of the private fund’s investors. The SEC stated its belief that advisers should also exclude fees and expenses associated with a subscription facility, such as interest expense, when calculating net performance figures and preparing the statement of contributions and distributions.
  21. The proposal defines a “liquid fund” as any private fund that is not an “illiquid fund.”
  22. A “fairness opinion” is defined as a written opinion stating that the price being offered to the private fund for any assets being sold as part of an adviser-led secondary transaction is fair. The SEC requested comments on whether it should permit an adviser to obtain a third-party valuation in lieu of a fairness opinion.
  23. An “independent opinion provider” is defined as an entity that (i) provides fairness opinions in the ordinary course of its business and (ii) is not a related person of the adviser.
  24. The SEC stated that whether a business relationship would be material under the proposed rule would require a facts and circumstances analysis. However, it believes that audit, consulting, capital raising, investment banking and other similar services would typically meet this standard.
  25. For private funds organized under non-U.S. law or that have a general partner or other manager with a principal place of business outside the United States, the financial statements must contain information substantially similar to statements prepared in accordance with U.S. GAAP and material differences with U.S. GAAP must be reconciled.