The SEC recently proposed new regulations for the private fund industry that would require annual audits and quarterly investor account statements, expand “prohibited activities,” limit preferential treatment, and other key changes. The proposals are intended to “enhance the regulation of private fund advisors and to protect private fund investors by increasing transparency, competition, and efficiency,” the SEC wrote in its release.

The full proposed rule, released Feb. 9, runs roughly 341 pages. Its comment period is set to end April 11 or 30 days after the proposed rules are published in the Federal Register, whichever is later; see the proposal for how to submit comments, as well as specific points on which the SEC is requesting feedback. (The same day, the SEC released proposed cybersecurity risk management rules for registered investment advisors and funds; read more here.)

While we do not expect this to be finalized in its current form, we recommend that advisors start reviewing their compliance procedures against these guidelines and preparing for possible changes. Read on for an overview of top points to be aware of now.

Quarterly account statements 

Investment advisors would have to provide quarterly account statements to all private fund investors within 45 days after quarter-end. These would require fund-wide reporting, not just personalized investor performance, and would have to include certain information regarding fees, expenses, and performance for each fund. As listed in the proposed rules, fund performance would be based on:

• For liquid funds, net total return on an annual basis since the fund’s inception, over prescribed time periods, and on a quarterly basis for the current year.
• For illiquid funds, the internal rate of return and a multiple of invested capital.

Mandatory private fund advisor audits

Private fund advisors would have to obtain annual audits of their funds’ financial statements. This would mean that managers that rely on surprise examinations to comply with the custody rule would now be required to provide audits for those funds – there would no longer be a choice. Audits, which would also be required upon liquidation, would have to be distributed to current investors “promptly” after completion, rather than within a specific time period (i.e., 120 or 180 days after year-end). 

Additionally, auditors would have to notify the SEC if they were terminated or resigned, or issued a modified opinion.

Advisor-led secondaries

Noting that advisors “have become increasingly active in the secondary market,” the SEC is proposing requiring advisors to obtain a fairness opinion from an independent opinion provider in connection with “certain advisor-led secondary transactions where an advisor offers fund investors the option to sell their interests in the private fund, or to exchange them for new interests in another vehicle advised by the advisor.”

Prohibited activities

Advisors would be prohibited from engaging in “certain sales practices, conflicts of interest, and compensation schemes that are contrary to the public interest.” This rule would apply to all advisors to private funds, regardless of whether they are registered with the SEC; i.e., it also applies to exempt reporting advisors and those prohibited from registration. As listed in the proposed rule, the prohibited activities are:

• Charging certain fees and expenses to a private fund or portfolio investment, including accelerated monitoring fees; fees or expenses associated with an examination or investigation of the advisor or its related persons by governmental or regulatory authorities; regulatory or compliance expenses or fees of the advisor or its related persons; or fees and expenses related to a portfolio investment on a non-pro rata basis when multiple private funds and other clients advised by the advisor or its related persons have invested (or propose to invest) in the same portfolio investment;
• Reducing the amount of any advisor clawback by the amount of certain taxes (which may have significant implications in how distribution waterfalls are structured);
• Seeking reimbursement, indemnification, exculpation, or limitation of its liability by the private fund or its investors for a breach of fiduciary duty, willful misfeasance, bad faith, negligence, or recklessness in providing services to the private fund; and
• Borrowing money, securities, or other fund assets, or receiving an extension of credit, from a private fund client.

Preferential treatment

The proposed rules would prohibit all advisors “from providing preferential terms to certain investors regarding redemption or information about portfolio holdings or exposures,” as well as prohibit them from providing any other preferential treatment to any fund investor unless they disclose to prospective and current investors – in writing – all preferential treatment they’re providing to other investors in the same fund. This would have a major impact on side letter agreements. Like the “prohibited activities” rule, this rule would apply to all private fund advisors, regardless of whether they are SEC-registered.

• Recordkeeping: Registered advisors would have to retain certain specified “books and records” to show they complied with this rule.

Annual reviews of compliance 

All advisors registered with the SEC would have to document the annual review of their compliance policies and procedures in writing.

Timing 

The SEC proposes a one-year transition period, beginning one year after the rules’ effective dates.

What does CohnReznick think?

Whether or not these rules and amendments pass as proposed, investors will be looking for them to be addressed. Advisors to private funds should review existing side letters and also take the proposed regulations into consideration for future side letters. Advisors should also take a second look at their compliance manuals, especially with the proposed cybersecurity regulations, and begin incorporating cyber-specific controls within them.   

Contact our team to learn more about how these proposed regulations could affect your fund.

Contact

William D. Pidgeon, CPA, Partner, Co-Leader, Financial Services Industry

786.687.7504

Marc J. Wolf, CPA, Partner, Co-Leader, Financial Services Industry

310.843.8274

Christopher G. Aroh, CPA, Partner, Financial Sponsors Industry Leader

959.200.7284

Gary Berger, CPA, Partner, Northeast Leader, Financial Services Industry

646.625.5733

Joshua L. Blumenthal, CPA, Partner

646.448.5411

Jeffrey Moskowitz, CPA, Partner

646.448.5461