On February 9, 2022, the Securities and Exchange Commission (SEC) voted to propose new rules and amendments to the Investment Advisers Act of 1940 that, if adopted, will significantly affect private fund advisers. Below highlights the primary changes and their potential impact.
Proposed Investment Advisers Act Changes
1. Private fund advisers registered with the SEC will be required to provide quarterly account statements to investors within 45 days after each calendar quarter-end.
The quarterly account statements would be required to disclose the following information:
- Fee and expense disclosures, including:
- Compensation, fees and other amounts paid to the private fund adviser or its related parties with cross-references to the governing documents that dictate the calculations;
- Other expenses paid by the private fund with separate line items, including, but not limited to, organizational, accounting, legal, administration, audit, tax, due diligence, travel etc. with cross references to the governing documents that disclose the expenses;
- Any offsets, waivers and/or rebates carried forward during the reporting period to subsequent quarterly periods that are to reduce future payments or allocations to the adviser or its related parties.
- All portfolio investment compensation allocated or paid by each portfolio investment to the investment adviser or its related parties
- The private fund’s ownership percentage of each portfolio investment
- Standardized fund performance information based on the type of fund:
- Liquid funds would disclose net total return on an annual basis since inception and on a quarterly basis for the current year;
- Illiquid funds would disclose performance based on the internal rate of return and a multiple of invested capital;
- Criteria used and assumptions made in calculating the performance will need to be disclosed.
2. Private funds will be required to have an annual audit and a liquidation audit.
- Financial statements must be prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP) or reconcile to U.S. GAAP
- Audit must be conducted in accordance with auditing standards generally accepted in the United States of America
- Auditor must be registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board (PCAOB)
- Auditors must notify the SEC if terminated or if they issue a modified opinion
3. Fairness opinions will be required for an adviser-led secondary transaction.
4. Private fund advisers would be prohibited from conducting certain activities.
- Adviser could not charge certain fees and expenses to a private fund or portfolio investment, including:
- Accelerated monitoring fees
- Fees or expenses associated with a regulatory and/or governmental examination or investigation of the adviser or its related parties
- Fees and expenses related to a portfolio investment on a non-pro rata basis to multiple funds and/or other clients
- Advisers also cannot:
- Reduce the amount of any adviser claw back by the amount of certain taxes
- Seek reimbursements, indemnification, exculpation or limitation of adviser liability by the private fund or its investors for breach of fiduciary responsibility, willful misfeasance, bad faith, negligence or recklessness,
- Borrow money, securities or other fund assets, or receive an extension of credit, from a private fund client
- Advisers cannot give preferential treatment to certain investors (regardless of registration status with the SEC) that has a material negative effect on other investors in the private fund, such as:
- Preferential redemption terms
- Information about portfolio holdings or exposures
- Other preferential treatment, such as side letter arrangements for fees and/or other agreements that are not disclosed to all existing and prospective investors
5. All private fund advisers registered with the SEC would need to document in writing the annual review of its compliance programs.
Potential Impact to Private Fund Advisers
Advisers would need to comply with these proposed rules and amendments one year following the adoption of the proposal. That would be sixty days after the date of publication in the Federal Register. This proposal, if adopted, could potentially impact all private fund advisers in a very meaningful way:
- There will be a significant amount of administrative time required to prepare the quarterly account statements. In addition, the quarterly account statements need to be provided within 45 days, creating a quick turnaround of monthly accounting to provide this information to investors. This could be a challenge to all funds, but even more acute for funds that have complex structures and need to value hard-to-value illiquid investments.
- All private fund advisers that are registered with the SEC must obtain audits for their private funds. Exemptions under the custody rule or otherwise will no longer help a fund avoid an audit requirement. In addition, these audits will need to be performed by auditors that are registered and inspected by the PCAOB, creating additional expenses investors must bear — likely with the greatest impact falling on smaller private funds. And for funds that have not been audited previously, this would impact expense ratios and performance on a prospective basis. Lastly, there will need to be a written agreement between the private fund adviser and their auditor that the auditor will need to communicate with the SEC if terminated or they issue a modified opinion. Should these notifications occur, the SEC would likely pay additional attention to the private fund adviser.
- The SEC has made it clear that if a private fund adviser enters an adviser-led secondary transaction, it will be subject to scrutiny. Specifically, private fund advisers will need to have a fairness opinion on the transaction performed. Third-party service providers that provide this type of service will need to be vetted thoroughly. Going through this process will require the private fund adviser to have personnel to manage the fairness opinion process. This could put strain on the private fund adviser’s employees and/or require retention of additional employees, impacting the adviser’s overall profitability.
- Private funds will also be prohibited from running certain expenses through their private funds, and the SEC has clearly signaled they will apply more scrutiny to this area. This also may impact a private fund adviser’s profitability. In addition, offering and governing documents may need to be revised to ensure they are specific in terms of the type of expenses that are charged to the fund to make it clear to regulators and investors. Expenses will also need to be referenced to the appropriate section of the governing documents on the quarterly account statement. Resources will be required to manage these changes and legal counsel will need to be consulted, representing additional time and expense. Lastly, auditors will likely need to spend more time auditing the expense areas to ensure compliance.
- Private fund advisers would no longer be able to seek reimbursements, indemnification, exculpation or limitation of adviser liability by the private fund or its investors for breach of fiduciary responsibility, willful misfeasance, bad faith, negligence or recklessness from private funds. As such, private fund advisers will need to consult with their legal counsel and consider whether any changes to the governing documents are required, should the SEC approve this proposal.
- Private fund advisers that continue to provide preferential redemption terms and/or information rights to certain investors will need to perform analysis to ensure those rights do not negatively impact other investors. This could be difficult to determine in advance and could increase regulatory risk to advisers; they will have to weigh the cost/benefit. In addition, this could make negotiations with prospective investors more difficult as well.
- Should private fund advisers continue to have side letters that offer differing fee structures etc., those terms would need to be disclosed to current and prospective investors. Determining the medium of disclosure and then engaging with the current and prospective investors will likely generate interesting discussions as to why there are differing terms. This will also likely cause additional time and expenses consulting with legal counsel and discussing with current and prospective investors.
- Written documentation of the annual compliance review will require additional resources to execute. This will likely add an additional level of regulatory time spent by the private fund adviser’s employees and/or require them to hire additional employees. All of this impacts the private fund adviser’s profitability.
There is a lot at stake for private fund advisers, making it important to consider the impact these proposed regulations could have on their business and whether it is in their best interest to provide comments to the SEC. The public comment period will remain open for 60 days following publication on the SEC website or 30 days following publication of the proposing release in the Federal Register, whichever period is longer.
Contact Corey McLaughlin at email@example.com or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.