The Securities and Exchange Commission (SEC) has approved new rules and amendments to the Investment Advisers Act of 1940 that are set to reshape the practices of private fund advisors.  While these changes aim to enhance transparency, comparability, and compliance across the industry, they mean that many fund advisors will need to reevaluate their practices and processes and, in some cases, implement massive management and operational changes. The new rules impact small, middle, and large market funds and will have a long-term impact on the private funds industry.

Here we break down some of the most impactful changes and provide actionable steps to prepare for this new reality. The Preferential Treatment Rule and Restricted Activities Rule will impact all private fund advisors; the remaining rules will impact only those advisors registered with the SEC.

Note: In Fall 2023, a lawsuit was filed in the 5th U.S. District Court of Appeals challenging the new private fund adviser rules. As of June 1, 2024, the outcome remains pending. The private fund community should watch for updates, and contact an advisor with any questions.

Rule #1: Preferential Treatment Rule

New Rule: The SEC now prohibits preferential terms for investors regarding certain redemptions or information on holdings and exposures, unless the redemption rights or information is offered to all investors. Other preferential terms are prohibited unless disclosed to current and prospective investors. This requirement aims to drive transparency across all investors in a fund, shedding light on previously undisclosed preferential treatment practices, including those tied to fund seeding and unique terms (side letters).

Action Step: Conduct a thorough review of existing side letters and investor agreements, particularly those involving preferential treatment and unique terms. Confirm alignment with the new disclosure requirements for any agreements entered into after the effective compliance date.

Rule #2: Restricted Activities Rule

New Rule: Advisors are now prohibited from engaging in certain activities “contrary to the public interest and the protection of investors,” including:

• Charging fees related to an investigation of the advisor without disclosure and consent from the investors. Expenses that are the result of a violation of the Advisers Act cannot be charged to the fund or its investors.
• Charging certain fees or expenses on a non-pro rata basis when expenses are shared among funds, unless the allocation is “fair and equitable.”
• Charging regulatory, examination, or compliance fees of the advisor, unless disclosed to investors.
• Borrowing from a private fund client without disclosure and consent from fund investors.
• Reducing the clawback by certain taxes, unless disclosed to the investors.

Action Step: Review and refine your approach to allocating fees and expenses tied to portfolio investments. Review investor agreements for prohibited activities. Make sure there are clear links between costs and fees, and provide transparency around them.

Rule #3: Quarterly Statement Rule

New Rule: Advisors now must distribute quarterly statements to investors, which must include year-to-date, annual, and since-inception (or 10 years for liquid funds) returns; a detailed breakdown of advisor compensation, fund expenses and fees, and offsets or rebates; and information regarding compensation paid by the fund’s investments to the advisor. This may particularly impact smaller advisors, who may face implementation challenges due to limited resources.

Action Step: Bring in third-party professionals to support a comprehensive understanding of the updated standards and confirm that they are being met. Take a critical look at your methodology for reporting performance to investors.

Rule #4: Private Fund Audit Rule

New Rule: Funds can no longer use the surprise security examination to comply with the Custody Rule. Instead, pooled investment vehicles must provide audited financial statements to investors within 120 days of the fund’s year-end. The financial statements must be prepared under U.S. GAAP and audited by a PCAOB-registered and -inspected firm.

Action Step: Coordinate with auditors and third-party administrators. If your fund was not previously audited, the initial audit will require more effort as the auditor will need to gain comfort on the beginning-of-the-year balances.

Rule #5: Advisor-led Secondaries Rule

New Rule: Registered private fund advisors now must obtain a fairness opinion or a valuation opinion when offering existing investors the option between selling their interests in a private fund and converting or exchanging their interests in the private fund for interests in another vehicle advised by the advisor (an Advisor-led Secondary Transaction). They must also distribute in writing any material relationships they have with the opinion provider. Certain transactions such as parallel fund rebalancing and “season and sell” transactions would typically not be in scope of this rule.

Action Step: Plan ahead for these types of transactions and identify a third-party service provider who can provide the fairness or valuation opinion.

What else you should know

Effective Dates: The rules will be effective 60 days after publication in the Federal Register, with a 12-month transition period for large advisors ($1.5 billion or more in AUM) and an 18-month transition period for smaller advisors (less than $1.5 billion in AUM), except for the Private Fund Audit Rule and Quarterly Statement Rule, which have an 18-month transition period.

Grandfathering: Prohibition aspects of the Preferential Treatment Rule and certain aspects of the Restricted Activities Rule will not apply to agreements entered into prior to the compliance date, if they would require the parties to amend those agreements.

Your best response: Professional assistance across the board

The new SEC rules signal a transformation in the private fund landscape. While challenges may lie ahead with their implementation, a proactive approach to compliance will help pave the way for greater investor trust and long-term success. Contact accounting advisors, consult legal counsel, engage third-party administrators, and continuously monitor changes to help ensure a seamless transition into this new regulatory era.

For more details, see the SEC’s fact sheet, press release, and full final rule.