On August 23, 2023, the Securities and Exchange Commission (SEC) adopted a final rule under the Investment Advisers Act of 1940 that imposes new audit and reporting requirements and prohibits certain actions by private fund advisers. The SEC press release stated that “The new rules and amendments are designed to protect private fund investors by increasing transparency, competition, and efficiency in the private funds market.”
Two rules, the quarterly reporting and annual audit requirement, will greatly increase the accounting and audit requirements for private fund advisors. For private fund advisers, the rules create new restrictions on how advisers charge fees and expenses and prohibits certain types of preferential treatment for investors.
The new rules are summarized in this SEC’s Fact Sheet and address:
Registered private fund advisers must distribute quarterly statements to investors that provide a detailed accounting of the private fund’s performance, fees and expenses paid during the reporting period. The statement must also disclose information regarding certain compensation or other amounts paid by the private fund’s portfolio investments to the adviser. For private funds that are not fund of funds, the quarterly statement must be distributed within 45 days of the end of the first three fiscal quarters and 90 days after the fiscal year end. Private funds that are considered fund of funds must distribute the quarterly statements within 75 days and 120 days, respectively.
Private Fund Audits
Registered private fund advisers must obtain an annual audit, conducted by an independent public accountant that is registered and subject to inspection by the PCAOB, for each private fund and the current exemption in the Custody Rule will no longer provide an exemption to the audit requirement. The audited financial statements must be presented in accordance with accounting principles generally accepted in the United States (US GAAP) and be audited under U.S. auditing standards. The audited financial statements must be distributed to investors within 120 days of the private fund’s fiscal year end. An audit would also be required upon liquidation.
There are some exceptions to the audit requirement where the private fund and the advisor are not in a control relationship.
Adviser-Led Secondary Transactions
Registered private fund advisers must obtain a fairness opinion or a valuation opinion when offering existing fund investors the option between selling their interests in a private fund and converting or exchanging their interests in the private fund for interests in another vehicle advised by the adviser or any of its related persons. The adviser must also prepare and distribute to the private fund’s investors a summary of any material business relationships the adviser has, or has had within the prior two years, with the independent opinion provider.
The new rules also address certain conflicts of interest and are restricted for all private fund advisers. This includes charging or allocating to the private fund fees or expenses associated with an investigation, or regulatory, examination or compliance fees of the adviser without disclosure and consent from fund investors. Additionally, advisers are restricted from charging fees or expenses related to an investigation that results or has resulted in a court or governmental authority imposing a sanction for a violation of the Advisers Act.
The rules also prohibit the adviser from reducing an advisor clawback by the amount of certain taxes without disclosure and borrowing from a private fund client without both disclosure and consent. Advisers are restricted from charging or allocating fees or expenses related to a portfolio investment on a non-pro rata basis unless the approach is fair and equitable and advance written notice is provided.
All private fund advisers are prohibited from providing preferential treatment agreements to limited partners regarding certain:
a) Redemptions from the fund, unless the ability to redeem is required by applicable law or the adviser offers the preferential redemption rights to all other investors without qualification; and
b) Preferential information about portfolio holdings or exposures unless such preferential information is offered to all investors.
The rule also prohibits private fund advisers from providing preferential treatment to investors unless certain terms are disclosed in advance of an investor’s investment in the private fund and all terms are disclosed after the investor’s investment.
To avoid advisors and investors having to renegotiate existing contracts, the SEC adopted legacy status provisions applicable to certain of the restricted activities and preferential treatment provisions. It applies to those governing agreements entered into in writing prior to the compliance date and with respect to funds that have commenced operations as of the compliance date.
All registered advisers, including those that do not advise private funds, must document the annual review of their compliance policies and procedures in writing. The review should consider any compliance issues, changes to the business activities of the adviser and any rule changes that occurred during the previous year. The rule provides advisers flexibility with how this annual review should be documented.
Who Falls Under the Rules?
The rules are applicable to SEC-registered advisors as well as U.S. and non-U.S. private fund advisers currently relying on the SEC’s “exempt reporting adviser” (ERA) exemption.
Private Fund Industry Challenge
Industry groups representing some of the largest hedge funds, private equity and venture capital firms have indicated the rule will create a heavy compliance obligation that will increase costs, undermine competition and reduce investment opportunities. These groups have indicated there is a very real possibility of a legal fight over the SEC’s authority to make such broad changes to the private funds regulatory framework and have indicated they are reviewing the final rule closely.
When Must Firms Comply?
The audit rule and quarterly statement rule take effect 18 months after the date of publication in the Federal Register. A staggered approach has been taken with the adviser-led secondary transaction, the preferential treatment and the restricted activities rules. For these, there will be a transition period as follows:
- Advisers with $1.5 billion or more: 12 months
- Advisers with less than $1.5 billion: 18 months
Advisers must comply with the amended compliance rules within 60 days after the date of publication.
What Steps Can Advisers Take To Prepare?
Advisers should assess their preparedness to comply with the rules by determining whether in-house capabilities allow for:
- Timely distribution of detailed quarterly statements to investors and the identification of independent public accounting firms that specialize in audits of private funds;
- Written annual documentation of policies to comply with restricted activities requirements and preferential treatment rules;
- Fairness opinions and valuations
Weaver has significant experience in providing funds and advisors audit and compliance services and can assist with moving into compliance with the new rules, as well as make introductions to a number of third-party administrators that can provide support for the quarterly statement requirement. Contact us for assistance.