- The proposed rules would affect both SEC-registered private fund advisers and those exempted from registration—including VC fund managers.
- As proposed, the rules would raise the costs of compliance and likely have a disproportionate impact on emerging fund managers.
- We expect the SEC to adopt new private fund adviser rules—but public comment may influence their final form. You can take action by submitting a comment to the SEC by June 13.
Below, we’ll walk you through the proposed rules and the impact they’ll have on the private fund industry.
Context for the proposed rule changes
Since becoming chair of the Securities and Exchange Commission (SEC) in April of 2021, Gary Gensler has set an ambitious agenda. One of his top priorities is increasing transparency and accountability for private funds—which include hedge funds, private equity funds, and venture capital funds.
Over the past several decades, the market for these funds has come to play a crucial role in the U.S. economy. They’re a significant source of capital for small businesses—the startup economy, for example, depends on them. Private funds are now also a critical part of the investment strategy for the nation’s largest pension systems. In search of higher returns than what they can get from the public markets, pension systems (and other large institutional investors) allocate more capital to private market investments, largely through private funds.
As the $18 trillion-dollar private fund industry has grown in size and complexity, so too has the SEC’s regulatory scrutiny. In February, the SEC proposed significant new regulations that would expand its oversight of private fund advisers—generally, the general partners (GPs) of the fund. If passed, these new rules fundamentally change the relationship between a fund’s advisers and its investors (or LPs), which are typically institutional investors and high net-worth individuals.
Since 1940, the SEC has regulated investment advisers, but historically, it exempted private fund advisers from those requirements. After the 2008 financial crisis, the 2010 Dodd-Frank Act expanded industry oversight by requiring private funds to register with the SEC. At that time, Congress specifically exempted small fund advisers (those with less than $150 million in assets under management) and advisers to venture capital funds.
The SEC believes its recently proposed rules would bring greater efficiency and fairness to the private fund market by adding transparency, reducing conflicts of interest, and protecting private fund investors through better accountability. If enacted, the proposed rules would represent a significant departure from the status quo.
What would the proposed rule changes do?
The changes would impact all private fund advisers: both those who are registered with the SEC and those Congress explicitly decided to exempt from registration with Dodd-Frank.
New obligations for SEC-registered private fund advisers
The proposed rules would impose a number of substantive reporting, recordkeeping, and disclosure requirements on SEC-registered advisers to private funds. Right now, the below obligations would only apply to registered advisers. However, the proposal also asks whether they should apply to all advisers—which suggests the SEC is considering imposing them on venture capital advisers and other exempt reporting advisers, as well.
- Quarterly statements: Advisers would be required to prepare and distribute detailed quarterly statements to fund investors for any private fund they advise.
While many advisers already provide some form of periodic reporting to investors, the proposed rules would prescribe the form and manner of their reporting, as well as require detailed accounting and standardized disclosure of a number of items. These standardized quarterly statements would need to disclose fees, compensation, and expenses—both at the fund level and portfolio company level. They would also need to contain cross-references to provisions in the fund’s governing documents (such as the limited partnership agreement) that permit such charges.
By standardizing the calculation and disclosure of performance metrics, these proposals are meant to make it easier for investors to compare adviser performance data. But they will likely make regulatory compliance more costly.
- Annual fund audit: Advisers would be required to obtain an audit of all of their managed and advised funds at least annually and upon liquidation. The audit must be performed in accordance with U.S. Generally Accepted Accounting Principles (GAAP) by an independent public accountant registered with the Public Company Accounting Oversight Board (PCAOB).
- Adviser-led secondary transactions: Advisers have become increasingly active in the secondaries market. To address conflict of interest concerns, SEC-registered advisers would be required to obtain a “fairness opinion” for some adviser-led secondary transactions. If the adviser is offering fund investors the option to sell their interest in the fund—or exchange it for new interests in another investment vehicle managed by the same adviser (or a related person)—this obligation would kick in.
The fairness opinion would have to be provided by an independent source that provides such opinions in the ordinary course of business. All material business relationships between the adviser and independent opinion provider from the last two years would have to be disclosed.
- Books and records: With the new disclosure and audit obligations would come expanded SEC examination and oversight of compliance programs. To make that process more efficient, advisers would be required to maintain records of compliance, as well as records showing delivery of the disclosures to fund investors. All SEC-registered investment advisers—to private funds or otherwise—would also be required to document the annual review of their compliance policies and procedures in writing.
New prohibitions for all private fund advisers
Beyond the above obligations for SEC-registered advisers to private funds, the SEC is proposing a ban on some activities for all private fund advisers. They believe that these activities are “contrary to the public interest and the protection of investors.”
Prohibited activities: Even if they were fully disclosed with investor consent and expressly authorized in fund governing documents, some activities would be prohibited for all private fund advisers. These include:
- Limiting or eliminating liability for adviser misconduct, including by seeking reimbursement, indemnification, and exculpation—even in cases of negligence
- Charging portfolio investment fees for unperformed services, including monitoring, servicing, or consulting fees for services the adviser does not reasonably expect to perform
- Charging the private fund certain fees and expenses related to regulatory and compliance matters
- Reducing adviser clawbacks for taxes applicable to the adviser, overruling a standard practice of the industry
- Charging fees or expenses related to portfolio companies on a non–pro rata basis, and borrowing from private fund clients
- Prohibition of preferential treatment: Certain types of preferential treatment—known as side letters—would also be expressly prohibited. Advisers would not be allowed to provide preferential terms to investors relating to redemptions. They would not be allowed to share information about portfolio holdings or exposure rights with only some investors if they expect that such terms would have a negative effect on other investors in the fund or a similar vehicle. Other forms of preferential treatment, such as granting certain opt-out rights or lower management fees, could be permitted, but only if such treatment is disclosed to both current and prospective investors to the fund.
How would these changes affect private funds?
If adopted, these changes have the potential to significantly alter how the private fund industry operates. Several of them are meant to reflect current industry best practices, such as providing quarterly financial reporting. However, the SEC proposes to prescribe, for the first time, the form and manner of compliance. Doing so could greatly increase compliance costs and make private market capital more expensive.
There are no grandfathering provisions. If adopted, the changes would apply to existing contracts and agreements. Private fund advisers would have one year to modify their practices and the terms of existing funds. This would mean they might have to breach previously negotiated agreements in order to come into compliance.
These obligations are likely to have a disproportionate impact on small and emerging funds, which have fewer resources to spend on compliance. A higher cost for investment capital would also impact the fundraising abilities of small, privately owned businesses, such as early-stage startups.
While some LPs generally welcome the SEC’s proposed rule changes, they would likely create new challenges for private fund advisers. Overall, the substantive requirements and prohibitions in the proposal represent an expansion of SEC regulation of all private fund advisers, especially when taken together with other recent rulemaking actions. SEC Commissioner Hester Peirce described the agency’s proposed approach to private fund regulation as representing a “sea change” and “meaningful recasting” of the SEC’s mission.
Investment in private funds is generally limited to qualified purchasers and accredited investors, which the SEC has traditionally viewed as “sophisticated” and able to fend for themselves. With proposed rule changes that mandate prescriptive disclosures and prohibit certain practices, the SEC is trying to impose a regulatory regime more similar to that found in retail-focused investments. By blurring the distinction between accredited and retail investors, the proposed rules have caused some, including Commissioner Peirce, to question whether the accredited investor limitations make sense anymore.
The proposal is open for public comment until June 13, 2022.
The original comment period ended on April 25, 2022. Responding to pressure from the industry and Congress, the SEC reopened the comment period to allow more time for public input. After the comment period closes, SEC staff will make final recommendations to the Commission. The 3-1 Democratic majority at the Commission already supported the proposal, making it likely they’ll adopt the rules.
Private fund managers, including those exempted from SEC registration, should consult with their business and compliance teams to determine the impact the rules could have on their firms. Advisers and investors who wish to submit a comment related to the proposal’s impact can do so here.
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