SEC’s Proposed Private Fund Reforms – Finance and Banking

Marion Steward


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The SEC recently released proposed private fund reforms. These
rules and amendments are only proposed at this point and are
subject to public review and comment. The comment period will be
open for 30 days after publication in the Federal Register or April
11, 2022 (60 days after issuance), whichever is later. We expect at
least a few months, if not longer, between the end of the comment
period and the publication of any final rules. The Commission
proposed a one-year transition period following the rules’
effective dates to provide time for advisers to come into
compliance with the new and amended rules if they are adopted.

Quarterly Statement Rule (Proposed Rule 211(h)(1)-2)

  • The proposed rule would require a registered investment adviser
    to prepare a quarterly statement that includes certain information
    regarding fees, expenses, and performance (further described below)
    for any private fund that it advises and distribute the quarterly
    statement to the fund’s investors within 45 days after each
    calendar quarter end, unless a quarterly statement that complies
    with the proposed rule is prepared and distributed by another
    person (e.g., in the case of a sub-advised fund).

    • Under the definition of “distribute,” the statement
      would need to be sent to all investors (if the investor is a pooled
      investment vehicle controlled by the adviser or its related persons
      (defined consistently with Form ADV), investors in those pools must
      receive the statements).

    • The Commission has requested comment on whether to revise the
      definition of “distribute” (which is currently silent
      on this matter) to expressly include distribution by granting
      investors access to a virtual data room containing the quarterly
      statement.


  • The proposed rule would require advisers to consolidate
    reporting for substantially similar pools of assets to the extent
    doing so would provide more meaningful information to the
    fund’s investors and would not be misleading (e.g., in the
    case of parallel and master-feeder structures). In the case of a
    newly formed fund’s initial quarterly statement, the
    statement would include the first two full calendar quarters of
    operating results.

  • The proposed rules would exclude real estate funds relying on
    3(c)(5) from this requirement (and the SEC has asked for comment on
    that point).

  • The SEC has also asked commenters whether certain common
    private fund fee and expense arrangements should be prohibited
    (i.e., the “2 and 20 model,” fees at the fund level
    above certain maximum fees to be prescribed by rule, compensation
    from portfolio investments to the extent management fees are also
    received, performance-based compensation, management fees being
    charged as a percentage of committed capital, or certain other
    expense practices or arrangements, such as expense caps provided to
    certain, but not all, investors).

General Format and Content Requirements; Disclosure

  • The proposed rule includes general format and content
    requirements meant to improve legibility and to make comparing
    funds easier (but it purposefully does not go so far as to mandate
    a specific reporting structure).

    • The proposed rule would require fees and expenses to be listed
      as separate line items by total dollar amount per specific category
      (e.g., insurance premiums, administrator expenses, or auditor
      fees), representing a change from aggregated expenses that we
      commonly see in standard financial statements.

    • The proposed rule would also require an adviser to present the
      dollar amount of compensation and fund expenses before and after
      any reduction due to offset, rebate, or waiver for the reporting
      period.

    • An adviser would remain free to include other performance
      metrics in the statement as long as the quarterly statement
      presents the performance metrics prescribed by the proposed rule
      and complies with the other requirements in the proposed rule.


  • Each statement would need to include prominent disclosure
    regarding the manner in which expenses, payments, allocations,
    rebates, waivers, and offsets are calculated.

  • The quarterly statement would also need to include cross
    references to the relevant sections of the private fund’s
    organizational and offering documents that set forth the applicable
    calculation methodology.

Fund-Level Disclosure on Fees and Expenses

  • Under the proposed rule, advisers would be required to provide
    the following information in table format: (1) detailed accounting
    of all compensation, fees, and other amounts allocated or paid to
    the adviser or any of its related persons by the fund during the
    reporting period; (2) detailed accounting of all fees and expenses
    paid by the fund during the reporting period other than those
    listed in (1); and (3) the amount of any offsets or rebates carried
    forward during the reporting period to subsequent quarterly periods
    to reduce future payments or allocations to the adviser or its
    related persons.

    • Expenses would include, but not be limited to, organizational,
      accounting, legal, administration, audit, tax, due diligence, and
      travel expenses. They would also include start-up and
      organizational fees of the fund if they were paid during the
      reporting period.

Portfolio Investment-Level Disclosure on Compensation and
Ownership

  • Under the proposed rule, advisers would be required to provide
    the following information in table format: (1) a detailed
    accounting of all portfolio investment compensation allocated or
    paid by each covered portfolio investment during the reporting
    period; and (2) the fund’s ownership percentage of each such
    covered portfolio investment as of the end of the reporting period
    (or zero percent, with a description of the fund’s investment
    in such covered portfolio investment, in cases where the fund does
    not have an ownership interest – such as where the fund only
    holds a debt investment).

    • Portfolio investment compensation includes, but is not limited
      to, origination, management, consulting, monitoring, servicing,
      transaction, administrative, advisory, closing, disposition,
      directors, trustees, or similar fees or payments.

Performance Disclosure

  • In addition, the proposed rule would require an adviser to
    include standardized fund performance information in each quarterly
    statement provided to fund investors.

  • The proposed performance disclosure requirements of the
    quarterly statement rule would require an adviser first to
    determine whether its private fund client is an
    “illiquid” or “liquid” fund no later than
    the time the adviser sends the initial quarterly statement, because
    determining which requirements are applicable would be dependent on
    that characterization.

    • An illiquid fund would be defined as one that: (1) has a
      limited life; (2) does not continuously raise capital; (3) is not
      required to redeem interests upon an investor’s request; (4)
      has as a predominant operating strategy the return of the proceeds
      from disposition of investments to investors; (5) has limited
      opportunities, if any, for investors to withdraw before termination
      of the fund; and (6) does not routinely acquire (directly or
      indirectly) as part of its investment strategy market-traded
      securities and derivative instruments (e.g., private equity, real
      estate, and venture capital funds).

    • A liquid fund would include any other fund.

    • However, comment has been requested on whether the rule should
      eliminate these definitions and give advisers discretion to provide
      the proposed performance metrics that they believe most accurately
      portray the fund’s returns.


  • For illiquid funds, the proposed rule would require an adviser
    to show performance based on the IRR and a MOIC (both of which
    would have specific definitions to limit any deviations in
    calculating the standard performance prescribed by the proposed
    rule).

    • The proposed rule would require advisers to calculate
      performance measures for each illiquid fund as if the private fund
      called investor capital, rather than drawing down on fund-level
      subscription facilities (for which advisers would have to exclude
      fees and expenses).

    • An adviser would need to disclose the assumed fee rates
      including whether the adviser is using fee rates set forth in the
      fund documents, whether it is using a blended rate or weighted
      average that would factor in any discounts, or whether it is using
      a different method for calculating net performance.


  • An adviser to a liquid fund would need to show performance
    based on net total return (which is not currently defined in the
    proposed rule) (1) on an annual basis for each calendar year since
    the fund’s inception, (2) as average annual net total returns
    over the one-, five-, and ten- calendar year periods if applicable,
    and (3) as cumulative net total return for the current calendar
    year as of the end of the most recent calendar quarter, as well as
    on a quarterly basis for the current year.

    • If the adviser made any assumptions in performing that
      calculation, such as whether dividends were reinvested, the adviser
      would need to disclose those assumptions in the quarterly
      statement.


  • The proposed rule would require an adviser to display the
    different categories of required performance information with equal
    prominence.

  • An adviser would not be able to provide the information only in
    a separate document, website hyperlink or QR code, or other
    separate disclosure.

Private Funds Adviser Audit Rule (Proposed Rule 206(4)-10)

  • A second proposed rule would require advisers to obtain an
    annual audit of the financial statements of the private funds they
    manage, as well as on liquidation, unless the fund otherwise
    undergoes such an audit.

  • If enacted as proposed, the audit would need to: (1) be
    performed by an independent public accountant that meets the
    standards of independence in rule 2-01(b) and (c) of Regulation S-X
    that is registered with and subject to regular inspection of the
    PCAOB; (2) meet the definition of audit in rule 1-02(d) of
    Regulation S-X, the professional engagement period of which shall
    begin and end as indicated in Regulation S-X rule 2-01(f)(5); and
    (3) be prepared in accordance with GAAP, or in the case of a
    foreign private fund, contain information substantially
    similar.

  • “Promptly” after completion, the audited financial
    statements would need to be distributed.

    • While the deadline is not concrete, the Commissioners do
      reference 120 days as a generally reasonable timeline absent
      extenuating circumstances.


  • For a fund that the adviser does not control and that is
    neither controlled by nor under common control with the adviser
    (e.g., where an unaffiliated sub-adviser provides services to the
    fund), such adviser would only need to take all reasonable steps to
    cause the fund to undergo an audit that would meet these
    elements.

  • Moreover, the proposing release notes that the Commission
    considered additional modifications to the audit requirement for a
    private fund during liquidation but was concerned that allowing for
    less frequent auditing (e.g., every 18 months or two years) during
    an entity’s liquidation might expose investors to abuse that
    could then go unnoticed for prolonged periods.

  • Additionally, under the proposed rule, there would need to be a
    written agreement between the adviser or the private fund and the
    auditor pursuant to which the auditor would be required to notify
    the Division of Examinations promptly (i) upon issuing an audit
    report to the private fund that contains a modified opinion and
    (ii) within four business days of resignation or dismissal from, or
    other termination of, the engagement, or upon removing itself or
    being removed from consideration for being reappointed.

Adviser-Led Secondaries Rule (Proposed Rule 211(h)(2)-2)

  • The proposed adviser-led secondaries rule would prohibit an
    adviser from completing an adviser-led secondary transaction with
    respect to any private fund, unless the adviser distributes to
    investors in the private fund, prior to the closing of the
    transaction, a fairness opinion from an independent opinion
    provider and a summary of any material business relationships the
    adviser or any of its related persons has, or has had within the
    past two years, with the independent opinion provider (i.e., one
    that (i) provides fairness opinions in the ordinary course of its
    business and (ii) is not a related person of the adviser).

  • The proposed rule would require an adviser to prepare and
    distribute to private fund investors a summary of any material
    business relationships the adviser or any of its related persons
    has, or has had within the past two years, with the independent
    opinion provider.

    • For purposes of the proposed rule, audit, consulting, capital
      raising, investment banking, and other similar services would
      typically meet the business-relationship standard.


  • Defined Terms Specific to the Proposed Rule

    • Fairness opinion would mean a written opinion stating that the
      price being offered to the private fund for any assets being sold
      as part of an adviser-led secondary transaction is fair.

    • The rule would define adviser-led secondaries as transactions
      initiated by the investment adviser or any of its related persons
      that offer the private fund’s investors the choice to: (i)
      sell all or a portion of their interests in the private fund; or
      (ii) convert or exchange all or a portion of their interests in the
      private fund for interests in another vehicle advised by the
      adviser or any of its related persons.

      • Examples of such transactions may include single asset
        transactions (such as the fund selling a single asset to a new
        vehicle managed by the adviser), strip sale transactions (such as
        the fund selling a portion of multiple assets to a new vehicle
        managed by the adviser), and full fund restructurings (such as the
        fund selling all of its assets to a new vehicle managed by the
        adviser).

Prohibited Activities Rule (Proposed Rule 211(h)(2)-1)

  • The proposal would prohibit all private fund advisers,
    including those that are not registered, from engaging in certain
    activities and practices, regardless of whether a fund’s
    governing documents permit such activities or whether they are
    disclosed or consented to, or whether they are performed
    indirectly.

  • These practices, which are further described below, include:
    (1) accelerated payments, characterized as fees for
    “unperformed services”; (2) certain regulatory and
    compliance fees and expenses; (3) reduction of adviser clawbacks
    for taxes; (4) limitation or elimination of liability for adviser
    misconduct; and (5) certain non-pro rata fee and expense
    allocations.

  • The Commission has asked for comment on whether the rule should
    apply to all advisers as proposed (as opposed to only registered
    advisers), and whether the prohibitions should only take effect if
    the adviser does not satisfy certain governance and other
    conditions (e.g., disclosure to investors in all relevant
    funds/vehicles, or approval by a limited partner advisory committee
    (or other similar body) or directors).

Accelerated Payments

  • The proposed rule would prohibit an adviser from charging a
    portfolio investment “accelerated payments,” including
    those fees assessed for monitoring, servicing, consulting, or other
    services in respect of any services the investment adviser does
    not, or does not reasonably expect to, provide to the portfolio
    investment.

  • However, the proposed rule would not prohibit an adviser from
    receiving payments in advance for services that it reasonably
    expects to provide to the portfolio investment in the future.

  • A fund with a 100% management fee offset would not comply if
    the adviser retained excess fees and no further management fee
    offset could be applied (e.g., at the end of fund life), and the
    private fund investors were not offered a rebate or other economic
    benefit equal to their pro rata share of any such excess
    fees.

Certain Regulatory Fees and Expenses

  • The prohibited activities rule would prevent an adviser from
    charging a fund for fees or expenses associated with an examination
    or investigation of the adviser or its related persons by any
    governmental or regulatory authority, as well as regulatory and
    compliance fees and expenses of the adviser or its related
    persons.

  • The proposed rule would allow charging funds for regulatory,
    compliance or other similar fees and expenses directly related to
    the activities of the fund (e.g., costs associated with a
    regulatory filing of a fund, such as Form D).

    • Where proper allocation is unclear, an adviser would be
      expected to allocate the fees and expenses in a manner that it
      believes in good faith is fair and equitable, and consistent with
      its fiduciary duty.

Reduction of Adviser Clawbacks for Taxes

  • The proposed rule would prohibit an adviser from reducing the
    amount of any adviser clawback by actual, potential, or
    hypothetical taxes applicable to the adviser, its related persons,
    or their respective owners or interest holders.

  • Adviser clawback means any obligation of the adviser, its
    related persons, or their respective owners or interest holders to
    restore or otherwise return performance-based compensation to the
    private fund pursuant to the private fund’s governing
    agreements.

  • The proposed rule release has asked whether the SEC should go
    even further, and prohibit deal-by-deal (i.e.,
    “American”) waterfalls altogether.

Limiting or Eliminating Liability for Adviser
Misconduct

  • The proposed rule would prohibit advisers, directly or
    indirectly, from seeking reimbursement, indemnification,
    exculpation, or limitation of liability by their funds or investors
    for a breach of fiduciary duty, willful misfeasance, bad faith,
    negligence, or recklessness in providing services to the
    funds.

  • Included in the specific types of contractual provisions that
    would be invalid is indemnification for breaching a fiduciary duty,
    regardless of whether state or other law would permit an adviser to
    waive its fiduciary duty.

Certain Non-Pro Rata Fee and Expense Allocations

  • The proposed rule would prohibit an adviser from directly or
    indirectly charging or allocating fees and expenses related to a
    portfolio investment (or potential portfolio investment) on a
    non-pro rata basis when multiple clients advised by the
    adviser or its related persons have invested (or propose to invest)
    in the same portfolio investment.

  • The proposed rule does not include an exception for omitting
    co-investment vehicles or other co-investors from fee and expense
    allocation related to dead deals.

    • The Commission has asked whether the proposed rule would make
      it difficult for funds to consummate larger investments where
      co-investment capital is needed or cause funds to syndicate more
      deals post-closing once the adviser is confident that the deal will
      not fall through.

    • It has also asked whether single-deal co-investment vehicles
      should be treated differently than multi-deal co-investment
      vehicles.

Borrowing or Receiving an Extension of Credit from a
Client

  • The proposed rule would prohibit an adviser from directly or
    indirectly borrowing money, securities, or other fund assets, or
    receiving a loan or an extension of credit, from a client, such as
    using fund assets as collateral in order to obtain a loan from a
    party other than the fund (i.e., borrowing against fund assets),
    accepting a loan offered by a private fund client, and taking
    advantage of a continuous line of credit extended by a private fund
    client.

  • The proposed rule would not prevent the adviser from borrowing
    from a third party on the fund’s behalf or from lending to
    the fund.

Preferential Treatment Rule (Proposed Rule 211(h)(2)-3)

  • Blanket Prohibition: The proposal would prohibit all
    private fund advisers, regardless of whether they are registered
    with the Commission, from (i) providing preferential terms to
    certain investors in private funds or in substantially similar
    pools of assets (such as parallel funds) regarding redemption, or
    (ii) providing certain information about portfolio holdings or
    exposures only to certain private fund investors if, in each case,
    the adviser reasonably expects such preferential terms or
    information to have a material, negative effect on other investors
    in the private fund.

  • Allowed with Disclosure: The rule would allow for
    other types of preferential treatment to be disclosed in advanced
    written notice to prospective investors and annual written notice
    to current investors, on the theory that other types of
    preferential treatment do not necessarily disadvantage other fund
    investors.

    • An adviser would need to describe specifically the preferential
      treatment to convey its relevance.

    • An adviser could comply with the proposed disclosure
      requirements by providing copies of side letters (with identifying
      information regarding the other investors redacted).


  • The timing of the proposed rule’s delivery requirements
    would differ depending on whether the recipient is a prospective or
    existing investor in the private fund.

    • For a prospective investor the notice would need to be
      provided, in writing, prior to the investor’s
      investment.

    • For an existing investor, the adviser would have to
      “distribute” the notice annually if any preferential
      treatment is provided to an investor since the last notice.


  • The proposed rule release asks (among a number of questions)
    whether the SEC should simply prohibit all preferential terms with
    respect to redemption, or (which may amount to the same thing) all
    preferential terms which could have a material, negative
    effect on other investors.

Books and Records and Written Annual Review of Compliance
Policies and Procedures

In addition, the proposal has included updates to the books and
records rule, new definitions, and a requirement that all
registered advisers, including those that do not advise private
funds, document the annual review of their compliance policies and
procedures in writing. The Commission has noted that the proposed
written documentation requirement is intended to be flexible to
allow advisers to continue to use the review procedures they have
developed and found most effective. In the context of the proposed
written documentation of annual reviews of compliance programs, the
Commission stated its concerns related to claims of the
attorney-client privilege, the work-product doctrine, or other
similar protections over required records, including any records
documenting the annual review under the compliance rule, based on
reliance on attorneys working for the adviser in-house or the
engagement of law firms and other service providers (e.g.,
compliance consultants) through law firms. It explained that
attempts to shield from, or unnecessarily delay, production of any
non-privileged record is inconsistent with prompt production
obligations and undermines the Commission staff’s ability to
conduct examinations.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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