On August 23, 2023, the Securities and Exchange Commission (the “SEC”) adopted several new and amended rules under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) to implement several changes to the business practices of private fund advisers (hereinafter the “Private Funds Rules”). These rules were first proposed in February 2022, and resulted in a flood of criticism and comments from across the industry. The SEC made several significant changes to the proposed rules and modified or eliminated some of the more controversial elements of the proposed rules, though what remains is still the most significant changes to the private fund adviser rules since the Dodd-Frank Act in 2010.
There are six new rules (and rule amendments) in total, which establish new obligations and restrictions that will impact the business practices of private fund advisers, whether they be registered investment advisers (“RIAs”) or exempt reporting advisers (“ERAs”). While most of the new rules apply only to RIAs, two of the rules – the Restricted Activities Rule and the Preferential Treatment Rule – also apply to ERAs. This article focuses on these two rules.
Restricted Activities Rule
Under the Private Funds Rules, private fund advisers, including ERAs, are now “restricted” from engaging in several types of activities, with the activities being allowed only upon specific disclosure and, in some cases, consent). The restricted activities are described below.
The following activities are allowed only upon sufficient disclosure to the fund investors:
- Charging or allocating to a private fund any regulatory or compliance fees and/or expenses which are unrelated to a governmental or regulatory authority investigation (such as fees associated with SEC filings such as Form ADV and Form PF, as well as certain state filings). These fees/expenses must be disclosed within 45 days of the end of the quarter during which the fees or expenses were incurred by the private fund client.
- Reducing the amount of general partner clawback by the amount of actual, potential, or hypothetical taxes applicable to the adviser, its related persons, or respective owners or interest-holders. All private fund advisers must now disclose both pre-tax and post-tax clawback amounts within 45 days after the end of the fiscal quarter in which the clawback occurs.
- Without prior notice to investors, charging or allocating to a private fund investment-related expenses on a non-pro rata basis across different private funds advised by the adviser all investing in the same investment. Before a private fund adviser may charge or allocate such fees or expenses on a non-pro rata basis, it must first distribute to each investor of the private fund a written notice of the non-pro rata fees and/or expense amounts and include a description of how the charge is fair and equitable under the circumstances.
The following activities are allowed only upon obtaining the advance consent of a majority of fund investors:
(i) Charging or allocating to a private fund client fees or expenses associated with a governmental or regulatory authority investigation of the adviser. If the adviser is sanctioned for violating the Advisers Act or the rules thereunder, the adviser may not charge the fees or expenses to the private fund client, even with consent.
(ii) Borrowing money, securities, or other fund assets from private fund clients or receiving an extension of credit from private fund clients.
Note the SEC expressly stated the consent of the limited partner advisory committee (“LPAC”) would not be sufficient.
Under the Private Funds Rules, “grandfathering” applies for all “legacy” agreements in place as of the compliance date and is discussed in more detail below.
Preferential Treatment Rule
ERAs will also be subject to the “Preferential Treatment Rule.” Under this rule, advisers to private funds (regardless of whether RIAs or ERA), subject to the terms described below, will be prohibited from engaging in the following:
- Preferential Redemption Rights: A preferential redemption right is a protection given to certain private fund clients that enables them to have their interests redeemed on pre-negotiated terms. Private fund advisers will be prohibited from granting these preferential redemption rights to any private fund client that are not otherwise required by law and that the adviser reasonably expects or should expect to have a material, negative impact on the other private fund clients, unless the adviser offers such redemption rights to all private fund clients in the fund without qualification.
- Information Rights: Information rights allow certain private fund clients access to specific fund information regarding the portfolio holdings or exposures of a fund that other private fund clients do not have access to. Advisers will be prohibited from providing access to such information when the adviser reasonably expects or should expect that the disclosure of such information to a private fund client will have a material, negative impact on other private fund clients, unless the adviser offers the information to all private fund clients at substantially the same time. The SEC provides that among the factors an adviser may need to consider is whether information provided to certain investors – including in connection with their representation on the LPAC – should be subject to contractual provisions around non-use, in addition to nondisclosure and confidentiality.
- Preferential Treatment: Advisers will also be prohibited from providing either directly or indirectly any other preferential treatment to a private fund client unless the adviser notifies current and prospective private fund clients in the fund of such preferential treatment on the following basis: (a) any material economic preferences given to other investors must be disclosed in advance written notice to prospective investors prior to their admission to the fund; and (b) all preferential terms, whether material or not, must be disclosed to all investors in the fund no less than annually.
Advisers will need to provide current investors with written notice of all preferential treatments the adviser or its related persons have provided to other investors in the same private fund (i) for illiquid funds, as soon as reasonably practicable following the closing of the fund’s fundraising period and (ii) for liquid funds, as soon as reasonably practicable following the investor’s investment in the fund. While “as soon as reasonably practicable” will depend on the facts and circumstances, the SEC has set forth that distributing the notice within four weeks would generally be appropriate. Going forward, advisers will be required to provide current investors with a comprehensive, annual disclosure of all preferential treatment provided by the adviser or its related persons since the last annual notice. It is worth noting that the Private Funds Rules allow for “grandfathering” for all “legacy” preferential redemption and information rights agreements in place as of the compliance date and will be discussed in more detail in the next paragraph.
The Preferential Treatment Rule also dictates that disclosure of preferential terms will require specificity. For example, if an adviser provides an investor with lower fee terms in exchange for a significantly higher capital commitment than others, the adviser will need to describe the lower fee terms, including the applicable rate (or range of rates if multiple investors pay such lower fees), in order to provide sufficiently specific information as required by the rule. Providing copies of side letters with identifying information redacted (if applicable) would comply with the disclosure requirements, as would a sufficiently specific written summary of preferential terms, such as a compendium or master side letter covering all preferential terms.
One potential workaround would be for a fund to set up a parallel fund that is only for certain investors (e.g. investors above a certain investment threshold or otherwise strategically important). A strict interpretation of the Preferential Treatment Rule would allow an advisor to not disclose terms provided to investors in one fund with investors in another fund, even if the two funds are parallel funds.
Both the “Restricted Activities Rule” and the “Preferential Treatment Rule” allow for “grandfathering” and provide exceptions to the rules for any “legacy” contractual agreements that govern a private fund or that govern any borrowing, loan, or extension of credit entered into by the private fund as long as the agreements were entered into prior to the compliance date required by the respective rule. As such, under the Restricted Activities Rule, “legacy” agreements that provide for private fund clients being responsible for investigation-related expenses, or an adviser being able to borrow from private fund clients, are hereby “grandfathered” without the need to obtain investor consent. Under the Preferential Treatment Rule, “legacy” preferential redemption or information rights are “grandfathered” without the need to offer them to other investors. However, “grandfathering” does not apply to the requirement to notify all investors of other legacy preferential material economic terms nor to the requirement to provide advanced written disclosure to prospective investors of material economic preferences given to others. Accordingly, after the compliance date, all material economic preferences in side letters, regardless of when they were entered into, must be disclosed to prospective investors before they invest in the fund and advisers must timely disclosure any such terms to all investors in the fund in the required annual disclosure. Advisers are not required to disclose the identity of the specific investor that received a preferential term and can decide whether or not to anonymize that information.
In recognition of the complexities and expenses that advisers may encounter in conforming their business practices to the Private Funds Rules, the SEC has provided a transition period for most of the new rules before they take effect. As such, the transition period for compliance with both the Restricted Activities Rule and the Preferential Treatment Rule will be twelve (12) months after the date of publication in the Federal Register for “larger” private fund advisers (those that have $1.5 billion or more in private fund assets under management) and eighteen (18) months after the date of publication in the Federal Register for “smaller” private fund advisers (those that have less than $1.5 billion in private fund assets under management).
Non-US Investment Advisers
In adopting the Private Funds Rules, the SEC stated that the Restricted Activities Rule and the Preferential Treatment Rule will not apply to offshore ERAs with respect to their non-U.S. private funds (regardless of whether the funds have U.S. investors) but will apply to any U.S. domiciled Private Funds.
Although non-US investment advisers advising only non-US private funds are not technically subject to the Private Funds Rules, the rules represent a substantial change to the regulatory landscape for the private funds industry and may very well have precedential value for other countries’ regulatory regimes. It will also be important for non-US investment advisers, and particularly those contemplating a global fundraise, to become familiarized with the rules given that sophisticated, institutional investors may look to treat certain of such rules as best practices to be applied consistently across their fund investments.
The Private Funds Rules contain many significant changes to the regulatory framework of the private funds industry. There will be many new administrative burdens and costs impacting both RIAs and ERAs as a result of the Private Funds Rules. Advisers should evaluate their current business practices and start making the requisite updates to their practices to bring them into compliance with the Private Funds Rules. Private fund advisers are encouraged to consult a member of Ross Law Group, PLLC with any questions or requests for guidance or assistance.