New private fund rules likely to increase cost of compliance

28 March 2022 | Americas | Articles

The SEC’s proposed new rules for advisers to private funds were released last month. And while they may be reflective of industry best practices, codifying them into the mandatory regulatory framework may seriously impact the compliance costs of private fund advisers. It’s also important to note that the proposed rules contain a new requirement for all registered investment advisers, including those who do not manage private funds, to document annual compliance reviews in writing. 

While it remains to be seen how the proposed rules will be amended before any final rules are implemented, the sweeping amendments to the regulation of private funds heralds a change from the traditional principal-based approach to the regulation of investment advisers to a more rule-based rubric typically seen for registered investment companies and broker-dealers. This regulatory change may reflect the Commission’s desire to provide additional protection to private fund investors following industry wide shifts away from traditional registered funds, such as mutual funds or ETFs, to private funds and other unstructured pooled investment vehicles.

The proposal: Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews was released on February 9, 2022 and includes the following new rules to be adopted:

• Rule 206(4)-10 generally requires private funds undergo a financial statement audit at least annually and upon liquidation.
• Rule 211(h)(1)-2 requires an investment adviser to a private fund to prepare and distribute a quarterly statement to private fund investors that includes certain standardized disclosures, as prescribed by the rule, regarding the fees, expenses and performance.
  • Fee disclosures will include information at both the fund level and portfolio investment level and will include details on compensation and ownership of those investments.
  • Standardized performance disclosures will include details on liquid and illiquid holdings, including internal rates of return and multiple of invested capital performance for illiquid holdings.
• Rule 211(h)(2)-1 prohibits all private fund advisers from, directly or indirectly, engaging in certain sales practices, conflicts of interest, and compensation schemes. This includes prohibiting advisers from:
  • Charging certain fees and expenses to a private fund or portfolio investment (including accelerated monitoring fees, fees or expenses related to regulatory or compliance matters);
  • Charging or allocation expenses related to a portfolio investment on a non-pro rata basis when multiple private funds advised by the adviser have invested (or propose to invest) in the same portfolio investment;
  • Reducing the amount of any adviser clawback by the amount of certain taxes;
  • Limiting liability for adviser misconduct; and
  • Borrowing money, securities, or other fund assets from a private fund client.
• Rule 211(h)(2)-2 prohibits an adviser from completing adviser-led secondary transaction on behalf of a private fund unless, prior to the closing of the transaction, a fairness opinion from an independent opinion provider and a summary of any material business relationships are provided.
• Rule 211(h)(2)-3 prohibits a private fund adviser from engaging in certain types of preferential treatment, such as granting preferential terms to certain investors with respect to redemptions or providing information about portfolio holdings if the adviser reasonably expects that the information would have a material, negative effect on other investors. The proposed rule also prohibits any other preferential treatment to any investor in a private fund unless the adviser provides written disclosures to prospective and current investors in the private fund regarding all preferential treatment the adviser provides to other investors in the same fund.

Additionally, the existing compliance rule will be amended to include the requirement that investment advisers document the annual review of their compliance policies and procedures in writing.

While any final rules would include a transition period before required implementation deadlines, advisers may be caught flat footed if they have not considered how to leverage existing operational infrastructure and reporting capabilities to meet the requirements of the new rules. The ideal time to consider the impact of the new rules is during the firm’s annual review of its compliance program.  Advisers to private funds should consider the operational hurdles associated with implementing the proposed rules and be mindful of potential new costs, both in real dollars and in compliance minutes.

We can help

Our team of SEC specialists can help you navigate the new requirements and your ongoing regulatory compliance. We can support your annual compliance review and help you make sure your documentation meets the regulator’s expectations.