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SEC Adopts Rules to Strengthen Private Fund Adviser Regulation
Cory Gossard | 24 August 2023
SEC Adopts Comprehensive Rules to Strengthen Private Fund Adviser Regulation
At a meeting on August 24, the Securities and Exchange Commission (SEC) voted to adopt a series of new rules and amendments under the Investment Advisers Act of 1940, aimed at enhancing the regulatory framework for private fund advisers. These measures are designed to bolster investor protection and establish clearer guidelines within the private fund sector. There is an 18-month transition period for the audit rule and the quarterly statement, and the adviser-led secondaries rule differs for large and small fund advisers. Here is PINE's overview of the key impacts of the final rule release:
Requirements for Registered Private Fund Advisers
I. Quarterly Statement Rule
Private fund advisers registered with the SEC must now provide investors with quarterly statements that divulge vital details concerning private fund performance, fees, and expenses.
The rule has clear stipulations on the timeline for these disclosures. Non-fund of funds entities must distribute these statements within 45 days after the conclusion of the first three fiscal quarters and within 90 days post the fiscal year's end. For funds of funds, the corresponding timelines are set at 75 days after each of the first three quarters and 120 days following the fiscal year.
The quarterly statement rule is an attempt to increase transparency for investors by requiring private fund advisers to detail certain financial aspects.
The rule will require the following information to investors in a table format:
Quarterly Statement Performance Disclosure:
Before diving into performance disclosure mandates, advisers must categorize their private fund client as either a liquid or illiquid fund. This categorization drives the performance information shared.
Illiquid Fund Defined: A private fund that does not mandate redeeming interests upon an investor's wish and offers minimal chances for withdrawals before the fund's closure.
Performance Reporting for Liquid Funds: Advisers must report annual total net return for either the last ten fiscal years, or since the fund's inception (whichever is shorter). Advisers also must show performance over one, five, and ten fiscal years, along with the cumulative performance for the ongoing fiscal year up to the latest quarter.
Performance Reporting for Illiquid Funds: Advisers must report performance based on internal rates of return (IRR) and multiples of invested capital (MOIC) since the fund's inception. Additionally, they need to present an overview of contributions and distributions.
Performance Reporting Requirements for Illiquid Funds
An Adviser’s quarterly statement must detail contributions, distributions, and performance measures for the illiquid fund since its inception that are through the quarter covered by the statement. In good news for some advisers, if quarter-end numbers aren't ready when distributing the quarterly statement, advisers should use data from the previous quarter's end.
Quarterly Statement Rule Transition Period: 18-months after publication in the Federal Registry
II. Private Fund Audit Rule
Registered private fund advisers are obligated to arrange an annual financial statement audit for each private fund under their purview. This audit ensures accurate valuation of fund assets and safeguards against potential misappropriation of assets.
Private Fund Audit Requirements and Details:
Mandatory Annual Audit
Every private fund advised by an SEC-registered adviser must undergo an annual audit, that must align with the “custody rule.”
The initial proposed rule drew from the Advisers Act custody rule. However, it had differences which commenters believed could lead to confusion and felt redundant with the custody rule. For clarity, the final rule mandates that private fund advisers registered with the SEC must ensure their funds are audited in line with the audit provisions of the custody rule.
Recognizing that a surprise examination under the custody rule doesn’t meet the stipulations of this new rule, there's an exception in place. If the adviser doesn’t control the fund and the fund isn’t under common control with the adviser, then the adviser is required only to take reasonable measures to make sure the fund undergoes an audit satisfying the rule's conditions.
In addition to the annual audit, there's a requirement to promptly conduct an audit when a private fund is liquidated. This ensures financial accuracy and investor protection right up to the fund's termination.
Elimination of Surprise Examination:
This new rule essentially does away with the surprise examination option that was present in the custody rule for private fund advisers. While this might lead to additional costs for some investors, the SEC believes that the audits of financial statements offer pivotal extra layers of protection to private fund investors.
Private Fund Audit Rule Transition Period: 18-months after publication in the Federal Registry
III. Adviser-Led Secondaries Rule
In situations where existing fund investors are offered the choice to sell their interests or exchange them for another vehicle advised by the same adviser, fairness or valuation opinions must be obtained. A summary of any significant business relationships related to this process must also be shared with investors.
Adviser-Led Secondaries Rule Requirements and Details:
Adviser-Led Secondaries Rule Transition Period: Staggered based on private fund assets under management.
IV. Restricted Activities Rule
To counter potential harm to investors from conflicts of interest, the reforms introduce a rule restricting private fund advisers. This rule addresses activities contrary to public interest and investor protection, including:
Restricted Activities Rule Transition Period: Staggered based on private fund assets under management.
V. Preferential Treatment Rule
To mitigate negative impacts on investors, the reforms introduce a Preferential Treatment Rule, whereby private fund advisers are barred from:
Adviser-Led Secondaries Rule Transition Period: Staggered based on private fund assets under management.
Legacy Status: With a concession made in the final rule, alleviating the need for costly and time-consuming repapering exercise for advisers and investors, the Commission introduced a "legacy status," applying to the prohibitions in the Preferential Treatment Rule and the aspects of the Restricted Activities Rule that necessitate investor consent. This status is extended to governing agreements formed before the compliance date, provided that adjusting these agreements aligns with the rules' requirements.
VI. 206(4)-7 Annual Review - For All Registered Advisers
This final rulemaking included changes that apply to all registered investment advisers, not just those that manage private funds. The final rule will amend the annual review component of Advisers Act rule 206(4)-7 (the “Compliance Rule”) to require all SEC-registered advisers to document their annual review in writing.
Amended Compliance Rule Transition Period: 60-days from publication in the Federal Registry
VII. Inclusion of a grandfather clause
One compliance win stemming from the newest amendments is the inclusion of a grandfather clause. This means private fund advisers will no longer need to review and amend all existing fund documents, which translates to a great deal of savings both in time and legal-spend to bring the fund’s legal documents into compliance.
Conclusions from PINE
Investment Advisers, whether SEC registered, state registered, exempt, or otherwise, are encouraged to review the implications that this rulemaking may have on your business. PINE Advisor Solutions will continue to monitor these new rules and the final publication in the Federal Register and be working with our clients to support their implementation efforts during the transition period.
If you have questions about this adoption, implications it may have on your firm, or if you need assistance finding comfort and guidance with how to navigate these new requirements, please contact PINE at compliance@pineadvisorsolutions.com.
At a meeting on August 24, the Securities and Exchange Commission (SEC) voted to adopt a series of new rules and amendments under the Investment Advisers Act of 1940, aimed at enhancing the regulatory framework for private fund advisers. These measures are designed to bolster investor protection and establish clearer guidelines within the private fund sector. There is an 18-month transition period for the audit rule and the quarterly statement, and the adviser-led secondaries rule differs for large and small fund advisers. Here is PINE's overview of the key impacts of the final rule release:
Requirements for Registered Private Fund Advisers
I. Quarterly Statement Rule
Private fund advisers registered with the SEC must now provide investors with quarterly statements that divulge vital details concerning private fund performance, fees, and expenses.
The rule has clear stipulations on the timeline for these disclosures. Non-fund of funds entities must distribute these statements within 45 days after the conclusion of the first three fiscal quarters and within 90 days post the fiscal year's end. For funds of funds, the corresponding timelines are set at 75 days after each of the first three quarters and 120 days following the fiscal year.
The quarterly statement rule is an attempt to increase transparency for investors by requiring private fund advisers to detail certain financial aspects.
The rule will require the following information to investors in a table format:
- A clear breakdown of every fee, compensation, or other amount given to the adviser or related entities by the private fund during the reporting period. Notably, the rule won't allow for any item, no matter how small, to be grouped into vague categories or labeled as miscellaneous.
- A comprehensive breakdown of all costs borne by the private fund during the reported quarter, excluding the adviser compensations mentioned in the first point.
- Any deductions or rebates from the current quarter that are rolled over to upcoming quarters, aiming to decrease future payments to the adviser or their associates.
Quarterly Statement Performance Disclosure:
Before diving into performance disclosure mandates, advisers must categorize their private fund client as either a liquid or illiquid fund. This categorization drives the performance information shared.
Illiquid Fund Defined: A private fund that does not mandate redeeming interests upon an investor's wish and offers minimal chances for withdrawals before the fund's closure.
Performance Reporting for Liquid Funds: Advisers must report annual total net return for either the last ten fiscal years, or since the fund's inception (whichever is shorter). Advisers also must show performance over one, five, and ten fiscal years, along with the cumulative performance for the ongoing fiscal year up to the latest quarter.
Performance Reporting for Illiquid Funds: Advisers must report performance based on internal rates of return (IRR) and multiples of invested capital (MOIC) since the fund's inception. Additionally, they need to present an overview of contributions and distributions.
Performance Reporting Requirements for Illiquid Funds
- Gross Metrics:
- Advisers must disclose the gross internal rate of return and the gross multiple of invested capital for the entire illiquid fund.
- Computed with and without the impact of any fund-level subscription facilities.
- Net Metrics:
- The reporting should include the net internal rate of return and the net multiple of invested capital for the illiquid fund.
- Computed with and without the impact of any fund-level subscription facilities.
- Gross internal rate of return and gross multiple of invested capital for the realized and unrealized portions of the illiquid fund’s portfolio, with the realized and unrealized performance shown separately.
An Adviser’s quarterly statement must detail contributions, distributions, and performance measures for the illiquid fund since its inception that are through the quarter covered by the statement. In good news for some advisers, if quarter-end numbers aren't ready when distributing the quarterly statement, advisers should use data from the previous quarter's end.
Quarterly Statement Rule Transition Period: 18-months after publication in the Federal Registry
II. Private Fund Audit Rule
Registered private fund advisers are obligated to arrange an annual financial statement audit for each private fund under their purview. This audit ensures accurate valuation of fund assets and safeguards against potential misappropriation of assets.
Private Fund Audit Requirements and Details:
Mandatory Annual Audit
Every private fund advised by an SEC-registered adviser must undergo an annual audit, that must align with the “custody rule.”
The initial proposed rule drew from the Advisers Act custody rule. However, it had differences which commenters believed could lead to confusion and felt redundant with the custody rule. For clarity, the final rule mandates that private fund advisers registered with the SEC must ensure their funds are audited in line with the audit provisions of the custody rule.
Recognizing that a surprise examination under the custody rule doesn’t meet the stipulations of this new rule, there's an exception in place. If the adviser doesn’t control the fund and the fund isn’t under common control with the adviser, then the adviser is required only to take reasonable measures to make sure the fund undergoes an audit satisfying the rule's conditions.
In addition to the annual audit, there's a requirement to promptly conduct an audit when a private fund is liquidated. This ensures financial accuracy and investor protection right up to the fund's termination.
Elimination of Surprise Examination:
This new rule essentially does away with the surprise examination option that was present in the custody rule for private fund advisers. While this might lead to additional costs for some investors, the SEC believes that the audits of financial statements offer pivotal extra layers of protection to private fund investors.
Private Fund Audit Rule Transition Period: 18-months after publication in the Federal Registry
III. Adviser-Led Secondaries Rule
In situations where existing fund investors are offered the choice to sell their interests or exchange them for another vehicle advised by the same adviser, fairness or valuation opinions must be obtained. A summary of any significant business relationships related to this process must also be shared with investors.
Adviser-Led Secondaries Rule Requirements and Details:
- Definition: Adviser-led secondary transactions allow fund investors the option to either sell all or part of their interests in a private fund or convert/exchange them for interests in another vehicle managed by the same adviser or its related entities.
- Primary Requirements:
- Procurement and distribution of a fairness or valuation opinion from an independent entity.
- Distribution of a written summary detailing significant business associations between the adviser (or their related entities) and the independent opinion provider.
- Purpose of New Regulation: Address conflicts of interest between advisers and investors. Safeguard against advisers benefiting at the expense of private fund investors.
- Protection Mechanisms: Ensure investors are informed about financial intricacies through fairness or valuation opinions. Inclusion of an independent party for valuations reduces potential for manipulative or fraudulent activities.
Adviser-Led Secondaries Rule Transition Period: Staggered based on private fund assets under management.
- Large Private Fund Advisers ($1.5B or more in private fund AUM): 12-months from publication in the Federal Registry
- Small Private Fund Advisers (less than $1.5B in private fund AUM): 18-months from publication in the Federal Registry
IV. Restricted Activities Rule
To counter potential harm to investors from conflicts of interest, the reforms introduce a rule restricting private fund advisers. This rule addresses activities contrary to public interest and investor protection, including:
- Investigation Fees: No charging for self-investigation fees without investor consent, or if tied to sanctions.
- Regulatory Costs: Prohibiting charging regulatory fees without investor disclosure.
- Clawback Transparency: Advisers must disclose pre- and post-tax clawback amounts and cannot deduct certain taxes.
- Equitable Charges: Uneven fees for portfolio investments disallowed, except with fair notified approach.
- Borrowing Limits: Advisers can't borrow from clients without disclosing and obtaining investor consent.
Restricted Activities Rule Transition Period: Staggered based on private fund assets under management.
- Large Private Fund Advisers ($1.5B or more in private fund AUM): 12-months from publication in the Federal Registry
- Small Private Fund Advisers (less than $1.5B in private fund AUM): 18-months from publication in the Federal Registry
V. Preferential Treatment Rule
To mitigate negative impacts on investors, the reforms introduce a Preferential Treatment Rule, whereby private fund advisers are barred from:
- Providing preferential terms to investors for specific fund redemptions unless it's legally required or extended to all without conditions.
- Offering selective preferential information about portfolio holdings, unless equally offered to all investors.
- Granting preferential treatment to investors without disclosing terms before and after investment.
Adviser-Led Secondaries Rule Transition Period: Staggered based on private fund assets under management.
- Large Private Fund Advisers ($1.5B or more in private fund AUM): 12-months from publication in the Federal Registry
- Small Private Fund Advisers (less than $1.5B in private fund AUM): 18-months from publication in the Federal Registry
Legacy Status: With a concession made in the final rule, alleviating the need for costly and time-consuming repapering exercise for advisers and investors, the Commission introduced a "legacy status," applying to the prohibitions in the Preferential Treatment Rule and the aspects of the Restricted Activities Rule that necessitate investor consent. This status is extended to governing agreements formed before the compliance date, provided that adjusting these agreements aligns with the rules' requirements.
VI. 206(4)-7 Annual Review - For All Registered Advisers
This final rulemaking included changes that apply to all registered investment advisers, not just those that manage private funds. The final rule will amend the annual review component of Advisers Act rule 206(4)-7 (the “Compliance Rule”) to require all SEC-registered advisers to document their annual review in writing.
Amended Compliance Rule Transition Period: 60-days from publication in the Federal Registry
VII. Inclusion of a grandfather clause
One compliance win stemming from the newest amendments is the inclusion of a grandfather clause. This means private fund advisers will no longer need to review and amend all existing fund documents, which translates to a great deal of savings both in time and legal-spend to bring the fund’s legal documents into compliance.
Conclusions from PINE
“By enhancing advisers’ transparency and integrity, we will help promote greater competition and thereby efficiency. Consistent with our mission and Congressional mandate, we advance today’s rules on behalf of all investors — big or small, institutional or retail, sophisticated or not.”
– SEC Chair Gary Gensler, Press Release August 23, 2023: https://www.sec.gov/news/press-release/2023-155
Investment Advisers, whether SEC registered, state registered, exempt, or otherwise, are encouraged to review the implications that this rulemaking may have on your business. PINE Advisor Solutions will continue to monitor these new rules and the final publication in the Federal Register and be working with our clients to support their implementation efforts during the transition period.
If you have questions about this adoption, implications it may have on your firm, or if you need assistance finding comfort and guidance with how to navigate these new requirements, please contact PINE at compliance@pineadvisorsolutions.com.