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U.S. SEC adopts private fund reforms

06 Sep 2023

By Jennifer Dickinson, Senior Managing Director, U.S.

On August 23, 2023, the U.S. Securities and Exchange Commission (SEC) adopted the long-awaited private fund reforms. The final rule and a fact sheet are available on the SEC’s website.  While not as sweeping as the proposed rules, private fund managers should begin preparing for some significant changes to their business.

Final rule vs proposal

At a high level, the final rule differs from the proposal in three respects:

  1. Flat prohibitions on certain activities have largely been replaced with consent or notice/disclosure-based requirements.
  2. Two sets of rules now have a grandfathering mechanism, which the rule describes as “Legacy Status.” Legacy Status applies to existing funds with written contracts executed before the applicable compliance date that would have to be amended to comply with the rule
  3. Two controversial proposals have been dropped from the final rule: the prohibitions on indemnity for simple negligence, and charging fees for unperformed services (e.g. accelerated monitoring fees)

Scope and compliance dates

Some of the new rules will apply to all private fund advisers, including exempt reporting advisers (ERAs), state-regulated advisers, advisers relying on the foreign private adviser exemption, or advisers that are otherwise unregistered.

All of the rules apply to registered investment advisers (RIAs).

Compliance dates vary by rule and, in some cases, by an adviser’s private fund regulatory assets under management (RAUM).  All compliance dates given are from the date of publication in the Federal Register.

Private fund reforms: the key rule changes

1. Documented compliance program annual reviews – RIAs

Rule 206(4)-7 requires RIAs to conduct an annual review of their compliance programs. The new rule includes an amendment further requiring all RIAs to document this review. The compliance date for this rule is 60 days, which should be during the fourth quarter of 2023.  Firms that have not historically documented their annual review should work with their regulatory counsel or compliance consultant to discuss documentation strategies for their upcoming annual review cycle.

2. Private fund financial statement audits – RIAs

The Custody Rule requires RIAs with custody of client assets to retain an independent public accounting firm to conduct a surprise examination of client assets. Managers of private funds have always had the option to obtain a financial statement audit and deliver the audited financial statements to fund investors within 120 days after fiscal year-end. The surprise examination route, however, was also an available option. The new rule does away with that option and requires all private funds to be audited in accordance with the Custody Rule’s specifications.

The compliance date for this rule is 18 months, which should be during the first quarter of 2025.  Firms that have been relying on surprise examinations for any funds or SPVs should plan to transition to a full financial statement audit for the fund/SPV’s 2025 fiscal year.

3. Quarterly statements – RIAs

The new rule requires RIAs to provide quarterly reporting to fund investors and specifies the timing, content and formatting of those statements. Q1, Q2 and Q3 statements must be distributed within 45 days of quarter-end for funds, or 75 days for funds-of-funds (FoFs). The Q4 statement must be distributed within 90 days of fiscal year-end, or 120 days for FoFs.

Statements must contain:

  • Compensation table – including all fees and other amounts allocated or paid to the adviser or a related person, with categories (e.g. management fee, carried interest) and dollar amounts; all fees and expenses paid by the fund, with categories (e.g. organizational, legal, travel) and dollar amounts; and the amounts of any offsets or rebates
  • Portfolio investments table – including all portfolio investment compensation allocated or paid to the adviser or any of its related persons, with separate line items for each category, reflecting total dollar amounts both before and after the application of any offsets or rebates
  • Calculations and cross-references disclosure – including calculation methodologies and cross-references to the applicable provisions in the fund’s governing documents
  • Performance data – including the date as of which the performance figures are current through and the criteria and assumptions made in calculating performance. Reporting requirements differ for liquid vs illiquid funds, as follows:
    • Liquid funds: Advisers must show annual net total returns for the shorter of the past 10 fiscal years or since inception; average annual net total returns for 1, 5 and 10 fiscal year periods; and the cumulative net total return for the current fiscal year, as of the most recent fiscal quarter-end
    • Illiquid funds: Advisers must show gross IRR and MOIC; net IRR and MOIC; gross IRR and MOIC for the unrealized and realized portions of the fund’s portfolio, with unrealized and realized shown separately; and a statement of contributions and distributions

The compliance date for this rule is 18 months, which should be during the first quarter of 2025.

Of all the rules, the quarterly statement requirements are likely the most burdensome.  Accordingly, we recommend that firms start work right away with their internal accounting teams and third-party fund administrators to update their processes and forms.

4. Adviser-led secondaries – RIAs

Adviser-led secondary transactions, such as forming continuation vehicles to buy a portfolio company from a prior fund, will require a fairness or valuation opinion from an independent provider. Firms must also disclose any material business relationship that it has with the independent provider.

The compliance dates for this rule are 12 months for large firms (private fund RAUM of at least $1.5 billion), which should be during the third quarter of 2024, and 18 months for all others, which should be during the first quarter of 2025.

5. Restricted activities – All private fund advisers

This is one of two rules that applies to all private fund advisers, regardless of registration status. It restricts advisers from engaging in certain activities that the SEC considers contrary to public interest, unless certain notice is provided or consent is obtained – with an exception relating to the Legacy Status mechanism, applicable to the consent requirements only.

Restricted activities include:

  • Regulatory investigation expenses: Advisers must obtain consent from a majority of investors, unrelated to the firm, to allocate regulatory investigation expenses to the fund. Funds with Legacy Status are exempt from this requirement
  • Compliance or examination expenses: Advisers must provide written notice to investors if they are going to allocate compliance or examination-related expenses to the fund
  • Clawbacks: Advisers must provide written notice to investors if offsetting an adviser clawback for the effect of taxes
  • Non-pro rata allocations: Advisers must provide written notice to investors if allocating portfolio investment expenses on anything other than a pro-rata basis
  • Borrowings: Advisers must obtain consent from a majority of investors, unrelated to the firm, to borrow or receive credit from the fund. Funds with Legacy Status are exempt from this requirement

The compliance dates for this rule are 12 months for large firms (private fund RAUM of at least $1.5 billion), which should be during the third quarter of 2024, and 18 months for all others, which should be during the first quarter of 2025.

Accordingly, we recommend that firms work with fund counsel to determine whether these activities are included in the offering documents and what additional steps, if any, are needed to provide notice or obtain consent as prescribed in the rule.

6. Preferential treatment – All private fund advisers

This is the second of two rules that apply to all private fund advisers, regardless of registration status. It also includes the Legacy Status mechanism described above.

The new rule prohibits offering preferential terms to investors unless certain additional steps are taken:

  • Redemption rights: For redemption rights that would have a material, negative impact on other investors, advisers must offer the same rights to other investors in the fund
  • Holdings or exposure information: For holdings and exposure information that would have a material, negative impact on other investors, advisers must offer the same preferential information to other investors in the fund
  • Any other preferential treatment: Advisers must disclose any other preferential treatment given to an investor to the other investors in the fund

The compliance dates for this rule are 12 months for large firms (private fund RAUM of at least $1.5 billion), which should be during the third quarter of 2024, and 18 months for all others, which should be during the first quarter of 2025.

We recommend that firms review their side letters and discuss with fund counsel the approach to take the additional steps as prescribed by the rule.

7. Recordkeeping

RIA books and records requirements are updated to include the following items contemplated by the new rules:

  • Notifications and disclosures
  • Audited financial statements
  • Quarterly statements, with support for all calculations and entries in the statements
  • Fairness/valuation opinions
  • Records of the addressee(s) for all communications sent pursuant to the rules

Firms should identify the staff members that will be responsible for keeping these records and ensure that they are aware of the new requirements.

At IQ-EQ, our compliance consultants have the experience to handle all U.S. regulatory requirements of the SEC and will work with you to adapt these new rules to keep your firm compliant. Find out more about our U.S. regulatory compliance consulting services.

Working with IQ-EQ has been seamless – you and your team understand our business, advise us appropriately, and handle your side of our collective partnership so that we can focus on making good investment decisions. Evan Gibson SVP, Merchants Capital

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