February 9, 2022

SEC Proposes Radical Changes to Private Fund Regulation

On February 9, 2022, the U.S. Securities and Exchange Commission (the “SEC”) proposed a package of new rules and amendments that will significantly affect all private fund advisers, including those that are not registered with the SEC under the Investment Advisers Act of 1940 (the “Advisers Act”). This package covers a range of issues including (i) new prohibitions on certain conflicted activities (including the charging of certain fees and expenses such as accelerated monitoring fees and the non-pro rata allocation of broken deal expenses), (ii) new prohibitions on preferential treatment relating to redemptions and fund and investment information and increased transparency on other types of preferential treatment, (iii) new quarterly statements to investors on performance, fees and expenses, and adviser and related person compensation, (iv) enhanced annual audit requirements, and (v) new requirements relating to adviser-led secondary transactions (including a requirement to obtain a fairness opinion). If adopted, this package would prohibit activities that had previously been addressed through disclosure, while significantly expanding the information being provided to both private fund investors as well as the SEC with respect to its examination and enforcement activities. These proposals will be highly controversial and will solicit significant feedback from the private fund industry and other persons. We have briefly summarized the proposed rules below and will have additional detail forthcoming.

New Prohibitions and Requirements Applicable to All Private Fund Advisers (Including Registered Private Fund Advisers, Exempt Reporting Advisers And Other Unregistered Private Fund Advisers)

Prohibited Conflicted Activities. All registered and unregistered private fund advisers would be prohibited from engaging in any of the following practices: 

  • Charging certain fees and expenses to a private fund including (a) fees for “unperformed” services (such as accelerated monitoring fees), (b) expenses associated with an examination or investigation of the adviser by any governmental or regulatory authority, and (c) regulatory and compliance fees and expenses of the adviser or its related persons;

  • Seeking reimbursement, indemnification, exculpation, or limitation of its liability by the private fund or its investors for a breach of fiduciary duty, willful misfeasance, bad faith, negligence, or recklessness in providing services to the private fund;

  • Reducing the amount of an adviser clawback by actual, potential, or hypothetical taxes applicable to the adviser, its related persons, or their respective owners or interest holders;

  • Charging fees or expenses related to a portfolio investment on a non-pro rata basis (including non-pro rata allocations of “broken deal” expenses with respect to co-investment vehicles); and

  • Borrowing money, securities, or other fund assets, or receiving a loan or an extension of credit, from a private fund client.

Preferential Treatment Restrictions. All registered and unregistered private fund advisers would be (i) prohibited from providing preferential terms relating to redemptions or information about portfolio holdings or exposures and (ii) required to disclose not merely the existence of certain preferential arrangements with certain clients, but a sufficient description of all such preferential treatment to current or prospective investors (e.g. side letters).

New Prohibitions and Requirements Applicable to Registered Private Fund Advisers

Quarterly Statements on Performance, Fees and Expenses. A registered private fund would be required to distribute a quarterly statement to investors with:

  • A detailed accounting of all fees and expenses paid during the reporting period;

  • Information regarding compensation or other amounts paid by the private fund’s portfolio investments to the adviser or its related person; and

  • Information regarding the private fund’s performance — liquid funds would provide annual net total returns since inception, average annual net total returns over prescribed time periods, and quarterly net total returns for the current calendar year and illiquid funds would provide the gross and net internal rate of return and gross and net multiple of invested capital for the illiquid fund to capture performance from the fund’s inception through the end of the current calendar quarter.

Annual Audit Requirement for Each Private Fund and Auditor Notification Requirements. A registered private fund adviser would be required to subject its private funds to undergo an audit at least annually and upon liquidation by an independent public accountant. The accountant would also be required to notify the SEC with respect to a modified opinion or the termination of the accountant’s engagement (whether by resignation or dismissal).

Adviser-Led Secondary Transaction Requirements. A registered private fund adviser would be required to (i) obtain a fairness opinion in connection with an adviser-led secondary transaction from an independent opinion provider and (ii) prepare and distribute to investors a summary of any material business relationships between the adviser and any of its related persons the opinion provider over the past two years.

Other Amendments. The SEC is also proposing amendments to (i) the compliance rule to require the annual review be documented in writing and (ii) the books and records rule reflecting the requirement to retain records related to these new rules and amendments.