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In February 2022, the Securities and Exchange Commission (the “SEC” or the “Commission”) proposed sweeping new regulatory requirements under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) for investment advisers that provide advisory services to “private funds.” See https://www.govinfo.gov/content/pkg/FR-2022-03-24/pdf/2022-03212.pdf (the “Proposal”). At a meeting this past Wednesday, the Commission adopted those rules, with certain key changes, by a three to two vote. See https://www.sec.gov/files/rules/final/2023/ia-6383.pdf (the “Adopting Release”). Those new regulatory requirements, as adopted, narrow the regulatory differences between SEC-registered investment companies and private funds and significantly increase the Advisers Act regulatory burdens associated with managing a “private fund.” The applicability of the new rules is not linked to the size of an investment adviser’s assets under management.
The most administratively burdensome requirements – the quarterly statements and annual audit rules – apply only to SEC-registered investment advisers (other than to non-U.S. SEC-registered advisers in the context of their management of non-U.S. funds, whether or not those funds have U.S. investors). However, two of the new rules apply to any entity that is an “investment adviser” for purposes of the Advisers Act, whether or not SEC-registered, including to so-called Exempt Reporting Advisers (again subject to exclusions for certain non-U.S. non-SEC-registered advisers in the context of their management of non-U.S. funds).
The Adopting Release indicates that the proposals are motivated by a desire to make private funds more transparent to investors and to address practices that are perceived to involve conflicts of interest or deficient governance mechanisms. However, Commissioners Peirce and Uyeda (who cast the two “no” votes) raised questions regarding the need for extensive new regulations in a space that caters primarily to sophisticated investors, as well as regarding the statutory predicate for the new rules.
Although the Proposal was not focused on the managers of collateralized loan obligations (”CLOs”), it would (perhaps inadvertently) have included those managers within the scope of the proposed rules and substantially complicated the management of CLOs, without affording any clear regulatory benefits. In apparent response to the detailed CLO market concerns raised by the SFA, LSTA, SIFMA and other commenters on the Proposal, each of the newly adopted rules discussed below contains exclusions for investment adviser activities relating to “securitized asset funds.” A “securitized asset fund” is defined in newly adopted Rule 211(h)(1)-1 as “any private fund whose primary purpose is to issue asset-backed securities and whose investors are primarily debt holders.” This definition tracks the definition already used in Form PF and Form ADV; and, per the Adopting Release, is expressly intended to include CLOs. The Adopting Release indicates that the Commission excluded management of CLOs and other securitized asset funds from the new rules due to its recognition that these vehicles have structural features and risk profiles significantly different from the private funds at which the Proposal was targeted.
The Adopting Release makes clear that the new rules do apply to an investment adviser’s management of credit funds and real estate funds, as well as to hedge funds, private equity funds, venture capital funds and other non-securitized asset funds.
Quarterly Statement Rule
New Rule 211(h)(1)-2 under the Advisers Act requires an SEC-registered investment adviser to prepare quarterly investment statements for any private fund that it advises, directly or indirectly, and that has “operating results” for at least two fiscal quarters. If the fund is not a fund of funds, the statements must be distributed to investors within 45 days after the end of each of the fund’s first three fiscal quarters and 90 days after the end of each fiscal year. In the case of a fund of funds, those distribution dates are increased to 75 days after the end of each of the first three fiscal quarters and 120 days after the end of each fiscal year. (Distribution is not required if statements complying with the rule are prepared and distributed by another adviser.) In the case of private funds in a control relationship (e.g., a feeder fund under common control with a master fund), an adviser must look through the pooled vehicle investor to its underlying investors.
The statements must include certain specified information relating to the “reporting period” – presented both before and after the application of any offsets, rebates or waivers. Although the Proposal sought comment as to whether reporting should be made from the perspective of the ownership interests of individual investors, the rule, as adopted, requires reporting to be made only at the fund level. The rule requires advisers to consolidate reporting for “substantially similar pools of assets” to the extent doing so would provide more meaningful information to investors and would not be misleading.
The information to be reported on the quarterly statements includes:
Private Fund Mandatory Audit Rule
Although SEC-registered advisers that are subject to the Advisers Act “custody” rule – Rule 206(4)‑2 (the “IA Custody Rule”) – typically obtain annual audited financial statements for their pooled investment vehicles as a way to bypass the “surprise examination” requirement of that rule, the Adopting Release notes that not all SEC-registered investment advisers are subject to the IA Custody Rule and that the IA Custody Rule doesn’t mandate that the adviser obtain annual audits. Newly adopted Rule 206(4)-10 accordingly requires an SEC-registered investment adviser that is not already obtaining an IA Custody Rule audit with respect to a private fund that it directly or indirectly advises to cause such private fund to undergo an annual financial statement audit that meets the requirements of paragraphs (b)(4)(i) through (iii) of the IA Custody Rule. Those audited financial statements must be distributed to fund investors in the same manner required by paragraph (c) of the IA Custody Rule. As originally proposed, Rule 204(6)-10 would have imposed requirements separate from those of the IA Custody Rule; however, as adopted, satisfaction of the IA Custody Rule satisfies Rule 206(4)-10.
Among other things, each required annual audit must: (1) be performed by an independent public accountant meeting the standards for independence specified in Regulation S-X that is registered with and subject to regular inspection by the Public Company Accounting Oversight Board; (2) meet the definition of audit in Regulation S-X, which requires that financial statement audits be performed in accordance with U.S. GAAS; (3) be prepared in accordance with GAAP (except as otherwise interpreted by the SEC in the context of the IA Custody Rule); and (4) be delivered to investors within 120 days of the applicable fund’s fiscal year-end, as well as promptly upon any liquidation.
In the case of a private fund with which an adviser does not have some type of “control” relationship, the adviser would be prohibited from providing advice to the fund if the adviser “fails to take all reasonable steps” to cause the private fund to undergo a financial statement audit that meets the requirements of paragraph (b)(4) of the IA Custody Rule. As noted, “control” is defined in a manner identical to the definition used in the Glossary to the Form ADV.
Adviser-Led Secondaries Rule
New Rule 211(h)(2)-2 makes it unlawful for an SEC-registered investment adviser to complete an “adviser-led secondary transaction” with respect to any private fund unless the adviser: (1) obtains and distributes to investors a “fairness opinion” or “valuation opinion” from an “independent opinion provider” relating to the applicable asset price; and (2) prepares and distributes to investors a written summary of any material business relationships the adviser or any of its related persons currently has – or has had within the two years prior to the issuance of the fairness opinion or valuation opinion – with the independent opinion provider. Both such documents must be distributed to investors prior to the due date of the election form relating to the transaction. As originally proposed, Rule 211(h)(2)‑2 could have been satisfied only by receipt of a fairness opinion, not a “valuation opinion.”
“Adviser-led secondary” is defined to mean any transaction initiated by the adviser or any of its related persons that offers private fund investors the choice between: (1) selling all or a portion of their interests in the private fund; or (2) converting or exchanging all or a portion of their interests in the private fund for interests in another vehicle advised by the adviser or its related persons. Although the Proposal requested comment as to whether there are other transactions as to which a private fund adviser should be required to obtain a fairness opinion – e.g., certain cross-transactions between private funds it manages – the proposed definition of this term was not broadened.
Restricted Activities Rule
New Rule 211(h)(2)-1 – which applies to any person that is an “investment adviser” for purposes of the Advisers Act, whether or not registered with the SEC under the Advisers Act (subject to exclusions for certain non-U.S. advisers) – restricts certain practices that the Adopting Release characterizes as having persisted “despite our enforcement actions and that disclosure alone will not adequately address.” Those practices, which would be restricted whether they are engaged in directly by the adviser, or indirectly through a related person, are:
In certain cases, “grandfathering” (or “legacy”) treatment will be available with respect to the first and last bullet points above.
As originally proposed, the activities encompassed by each of the foregoing bullet points would have been subject to absolute prohibitions. However, as adopted, the rule permits those activities to occur, provided the applicable conditions are satisfied. The Proposal also would have precluded an adviser from seeking indemnification or limitation of liability for managerial actions that constitute “simple negligence” (as opposed to “gross negligence”), willful misfeasance, bad faith or recklessness. However, the Commission declined to include a straightforward prohibition, electing, instead, to “discuss [its] views on how an adviser’s fiduciary duty applies to its private fund clients and how the antifraud provisions apply to the adviser’s dealings with clients and fund investors.”
Preferential Treatment Rule
New Rule 211(h)(2)-3 similarly applies to any person that is an investment adviser for purposes of the Advisers Act (subject to exclusions for certain non-U.S. advisers – whether or not registered with the SEC under the Advisers Act) – and would prohibit such an investment adviser from:
“Grandfathering” (or “legacy”) treatment is potentially available with respect to both of the first two bullets.
Books and Records Rule Amendments
Rule 204-2 under the Advisers Act – the recordkeeping rule – was amended to make certain conforming changes. In particular, it requires retention of:
Compliance Rule Amendments
Rule 206(4)-7 under the Advisers Act was amended to require an SEC-registered investment adviser to document in writing the annual reviews that are undertaken pursuant to that rule, to assess the adequacy of the adviser’s compliance policies and procedures. (Unlike the newly-adopted rules, this longstanding rule and the amendments thereto apply equally to CLO managers.) The Adopting Release notes that the written documentation is meant to be available to the SEC and its staff and should be produced promptly upon request. The Proposing Release sought comment as to whether the SEC should require the written documentation to address matters similar to those that Rule 38a‑1 under the Investment Company Act of 1940 requires be addressed in the context of an SEC-registered investment company, e.g., each “material compliance matter” that occurred since the previous report. However, that approach was not followed.
The mandatory audit rule and the quarterly statement rule are subject to an 18-month transition period; i.e., compliance is required 18 months following publication of the Adopting Release in the Federal Register. The rules relating to adviser-led secondaries, preferential treatment and restricted activities have staggered transition periods, based upon the amount of the adviser’s assets under management. The amendments made to Rule 206(4)-7 become effective 60 days after the Adopting Release is published in the Federal Register.