New SEC private funds rules: What advisers need to know and how they can prepare

Annual audits | Quarterly Statements | Adviser-led Secondaries | Restricted Activities | Preferential Treatment

The SEC’s stated goal is to compel private fund advisers – including but not limited to private equity and venture capital funds, hedge funds and real estate funds – to be more transparent with investors and other stakeholders. There are more than 5,500 registered investment advisers (RIAs) with private fund clients and more than 15,000 RIAs in total. In light of the growth in the number of private funds and the continued increase in gross assets managed via private funds, ultimately, the SEC's objective is to see that investors receive more information in order to increase efficiency and competition in the private funds industry.

Among other changes, the Rule will obligate SEC-registered private funds to produce and share with investors annual financial statement audits and quarterly statements for each fund they advise. Other key mandates regulate advisor-led secondary offerings, spell out how advisers can offer certain investors preferential benefits, restrict important activities (with specific disclosure-based exceptions), and call for annual compliance reviews.

In the sections below, we will delve into more detail about important considerations for advisers in these areas. But from an overall strategic perspective, advisers need to begin planning now to stay ahead of the compliance realities. The clock began ticking when the Rule was published in the Federal Register on September 14, 2023.

Note that although the Rule is currently being challenged in the courts, it appears likely that some or all parts will become final, making advance preparation important. That said, current staggered compliance dates in accordance with the Rule are summarized below:

• Annual audits and quarterly statement rules: 18 months from the publication in the Federal Register (or mid-March 2025).
• Adviser-led secondaries, preferential treatment and restricted activities rules:
  • Advisers with $1.5 billion or more in assets under management (AUM): 12 months from the publication in the Federal Register (or mid-September 2024).
  • Advisers with less than $1.5 billion in AUM: 18 months from the publication in the Federal Register (or mid-March 2025).
• Amended compliance rule: 60 days from the publication in the Federal Register (or November 13, 2023).

It’s also important to be clear on the scope of the investment advisers that are subject to the Rule.

• Annual audits, quarterly statements, and adviser-led secondaries: Applicable to all RIAs that advise private funds (except for any securitized asset funds that they advise).
• Preferential treatment and restricted activities rules: All private fund investment advisers, whether registered with the SEC or not (except for any securitized asset funds that they advise).
• Amended compliance rule: Applicable to all RIAs.

Many advisers will need to invest a significant amount of resources within a relatively short timeframe to ensure full compliance on an ongoing basis. The organizations that adopt a plan now will be best positioned to successfully manage these compliance transformations with the least amount of disruption to their business and that of their limited partners.

Annual audits (Rule 206(4)-10)

Based on our early discussions with smaller private fund advisers, the greatest challenge for them may be complying with the new requirement for annual financial statement audits, to be conducted by an independent public accountant that is subject to annual inspection by the Public Company Accounting Oversight Board (PCAOB).

This change likely marks the end of the era for surprise custody examinations for pooled investment vehicles. Fund advisers that have been relying on them to satisfy investors’ desires for information will need to make a significant shift in operations and processes. A custody exam is an attestation in which an auditor evaluates how the fund adviser is complying with the SEC Custody Rule – both in terms of maintaining securities and cash with a capable custodian and maintaining all relevant records. Traditionally, this exercise has proven to be relatively painless (and cost-effective) for most fund advisers.

Despite the fact that private fund advisers have until March 2025 to comply, they need to begin preparing for this new reality now. Audits must be delivered to investors within 120 days of the end of a fund’s fiscal year-end (or 180 days for a fund of funds and 260 days for a fund of funds of funds). In situations where the sub-adviser is not affiliated with the private fund, the Rule specifies that the sub-adviser must “take all reasonable steps” to have the private fund audited. The SEC acknowledges that facts and circumstances will drive the definition of “all reasonable steps,” but provided an example as follows: “a sub-adviser that has no affiliation to the general partner of a private fund could document the sub-adviser’s efforts by including (or seeking to include) the requirement in its sub-advisory agreement.”

Recordkeeping obligations: Advisers should ensure that they keep (a) a copy of the audited financial statements sent, (b) a record of each addressee, (c) the date the audited financial statements were sent, (d) all records that support the information noted on the quarterly statements, and (e) documentation of all steps taken by the adviser to cause a private fund that it does not control to be audited. 

Quarterly Statements (Rule 211(h)(1)-2)

The Rule underlines the SEC’s position on providing clear¹ and transparent information to investors on a quarterly basis. Statements must be supplied within 45 days of the end of each of the first three fiscal quarters of every year and within 90 days of the end of the fiscal year. Fund-of-funds advisers are allotted more time: 75 days and 120 days, respectively. The Rule requires a “meaningful application of the distribution requirement,” meaning if an investor is itself a pooled investment vehicle that is under common control with the adviser, the adviser should look through the pooled structure to provide the statement to the investors in that structure.

From a governance standpoint, it will be important that advisers ensure not only that the data they deliver to investors fully conforms with the SEC’s new obligations, but that they strive to apply the quarterly statement rule consistently across various vehicles (including considering consolidated reporting for structures where that would be more meaningful). It is key to note that the SEC has specifically emphasized the principle-based approach for consolidated reporting for different fund structures due to the diversity and complexity of private fund structures. The SEC has pushed for consistency of application in similar situations – such as with the presentation of non-GAAP measures to investors – so we can expect a similar approach from the regulators under this new paradigm for private fund advisers.

From an operational standpoint, compliance with these quarterly reporting rules might represent a heavy lift for many fund advisers. Over and above the rapid timeframe mentioned earlier, advisers will need to provide investors with detailed information including:

• Fee and expense disclosures²:
  • Fund-level disclosures (in a tabular format):
    • All compensation, fees, amounts allocated or paid to the adviser or its related parties³ during the period (adviser compensation).
    • All fees allocated or paid other than those allocated or paid to the adviser or its related parties during the period (fund expenses).
    • Offsets/rebates applied during the period and carried forward during the period to future periods in order to reduce future allocations or payments to the adviser or its related parties.

The SEC has emphasized the need to provide detailed categories of adviser compensation and fund expenses to ensure that investors have a full understanding of both the amount and the type of expenses borne by the fund.

Information about offsets and rebates should be detailed enough, with the data provided enabling investors to see the gross expenses and the net expenses (after the application of any offsets or rebates).

• Portfolio investment-level disclosures (in a tabular format):
  • All compensation, fees, and amounts allocated or paid to the adviser or its related parties by the portfolio investment during the period (adviser compensation).
  • The investment compensation should be shown gross and net of any applicable offsets or rebates.

Similar to fund-level disclosures, advisers need to provide detailed categories of portfolio investment-level compensation to the adviser or its related parties.

In addition, the adviser should provide enough cross-referencing information for an investor to compare the requirements of the private fund’s organizational and offering documents to the actual expenses paid by or allocated to the fund.

• Performance disclosures:
  • Liquid funds:
    • Net total return (on an annual basis) for the past 10 fiscal years or from the fund’s inception if shorter than 10 years.
    • Average annual net total return over 1, 5, and 10 fiscal year periods, or shorter if the fund did not exist during that timeframe.
    • Cumulative net total return for the current fiscal year (as of the end of the most recent fiscal quarter).
  • Illiquid funds⁴:
    • Gross and net internal rate of return (IRR)⁵ since inception.
    • Gross and net multiple of invested capital (MOIC)⁶ since inception.
    • Gross IRR and MOIC for the realized and unrealized portions of the fund’s portfolio, with the realized and unrealized performance disclosed separately.
    • The above performance measures should be computed with and without the impact of fund-level subscription facilities.⁷
    • Statement of contributions and distributions. This statement should present the value and date of each capital inflow and outflow, and the net asset value of the private fund as of the end of the reporting period in the quarterly statement.

Recordkeeping obligations: Advisers should ensure that they keep (a) a copy of quarterly statements sent; (b) a record of each addressee; (c) the date the statements were sent; (d) all records that support the information noted on the quarterly statements; and (e) records that substantiate whether the private fund is liquid or illiquid.

Given these obligations, fund advisers should immediately begin their work to ascertain what additional investments they need to make in both internal and external resources. It seems likely that some advisers will engage third-party fund administrators in their enhanced quarterly reporting programs.

Adviser-led Secondaries (Rule 211(h)(2)-2)

The Rule also addresses circumstances where an adviser initiates and offers its fund investors the choice between (a) selling (all or a portion) of their interests in the private fund and (b) exchanging it for new interests in another investment vehicle that is advised by the adviser or its related parties. Tender offers, rebalancing (between parallel funds) and season-and-sell transactions are not included in the definition of adviser-led secondaries.

In the case of an adviser-led secondary, the adviser must do the following:

• Obtain and distribute a fairness opinion or a valuation opinion from an independent provider⁸ to the private fund’s investors (prior to the due date of the election form⁹). 
• Prepare and distribute a summary of any material business relationships between the adviser and the independent provider of the fairness opinion or valuation opinion (prior to the due date of the election form). The lookback period for material business relationships is defined as a two-year period immediately prior to the issuance of the opinion.

Advisers should ensure that they review their valuation or fairness opinion providers and evaluate all relationships with them. The related party evaluation might be more straightforward than evaluating the materiality of business relationships. Material business relationships are based on facts and circumstances, but the purpose of these amendments is to (a) provide additional transparency on adviser/provider relationships and (b) reduce the ability of an adviser to act in a manner contrary to the best interests of the fund investor.

Recordkeeping obligations: Advisers should ensure that they keep (a) a copy of fairness opinion or valuation opinion sent; (b) a copy of the summary of material business relationships with the independent provider; (c) a record of each addressee; and (d) the date the opinion and summary were sent.

Restricted Activities (Rule 211(h)(2)-1)

Under the Rule, the SEC has noted certain activities that are restricted for investment advisers unless there are certain disclosure-based exceptions (either before the fact or after the fact, depending on the exception) or disclosure- and consent-based exceptions. The SEC has continued to emphasize that these activities involve inherent conflicts of interest and are contrary to the public interest. However, based on the comment letters received in response to the proposed Rule, these restricted activities are not prohibited if there are disclosures to investors or disclosures and consent from investors.

Restricted Activities with disclosure-based exceptions:

• Advisers must provide written notice to fund investors of regulatory and compliance fees/expenses charged to or allocated to the fund that associated with an examination of the adviser or its related parties by any regulatory or governmental agency. This notice, including amounts, must be provided to the fund in writing on at least a quarterly basis. Examples of such costs might include (a) compliance consultants who assist the adviser with mock regulatory examinations to prepare the adviser, (b) costs for certain regulatory filings (such as Form ADV or Form PF), and/or (c) costs incurred related to a regulatory examination of the adviser, etc.
• Advisers must also provide written notice to fund investors of any reduction in adviser clawbacks for taxes at the end of the quarter during which such reduction has occurred. This notice must be provided to the fund in writing on at least a quarterly basis. It should disclose the aggregate dollar amounts of the adviser clawback before and after any reduction for actual, potential or hypothetical taxes.
• Advisers are prohibited from charging or allocating non-pro-rata fees and expenses (i.e., fees and expenses related to a portfolio investment that is in the portfolios of multiple funds advised by the adviser that are not charged/allocated on a pro-rata basis), unless they are able to meet the two requirements below:  
  • The non-pro-rata fee and expense allocation must be fair and equitable.
  • Prior to charging or allocating such fees and expenses, the adviser must provide each investor a notice of such allocation (in writing) and a description of how it is fair and equitable.

In the Rule, the SEC also provided some examples where a non-pro-rata allocation might be fair and equitable: “In another example, a factor could be whether the expense relates to a bespoke structuring arrangement for one private fund client to participate in the portfolio investment. As yet another example, another factor could be that one private fund client may receive a greater benefit from the expense relative to other private fund clients, such as the potential benefit of certain insurance policies.”

Restricted Activities with investor consent-based exceptions:

This portion of the Rule does have “legacy status,” meaning that there are grandfathering provisions available as long as (a) the fund commenced operations as of the compliance deadline, (b) the governing documents were entered into prior to the compliance deadline, and (c) the governing documents would have to be amended if this portion of the Rule was not grandfathered in.

• While the SEC initially proposed that fees related to the investigation of the adviser should not be charged to investors, the final Rule allows for such fees and expenses to be charged or allocated to a private fund if consent has been received (the governing documents of the fund also must allow for such charges). The adviser must ask for consent from all investors and must receive written consent from at least a majority of the investors that are not related to the adviser.¹⁰ However, if the fees and expenses relate to an investigation that results in a sanction for a violation of the Investment Advisers Act of 1940, they cannot be charged or allocated, and if already paid, they must be refunded or reversed. It should be noted that the legacy provisions do not apply in the case that an investigation results or resulted in a sanction; therefore, charging or allocating these fees or expenses to a fund is prohibited.
• The Rule requires that an adviser provide a written notice with a description of the material terms¹¹ of the borrowing to all investors in the fund and seek their consent. Consent must be received from at least a majority of the investors that are not related to the adviser prior to engaging in any borrowing. This restriction does not apply to tax advances or management fee offsets in the ordinary course of business.

Recordkeeping obligations: Advisers should ensure that they keep (a) a copy of the notification sent to investors, (b) a copy of the consent or other document sent or received from investors, (c) a record of each addressee, and (d) the date the documents were sent.

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

The SEC has moved to constrain how fund advisers offer certain investors preferential treatment, either with an outright prohibition or a prohibition if disclosures are not made. Legacy status (as described in the Restricted Activities section) is available for the prohibited preferential treatment of the Rule only.  

Prohibited preferential treatment:

• Advisers are no longer allowed to provide preferential redemption rights to certain investors unless (a) redemptions are required by law or regulation, or on order of certain governmental authorities and (b) if the preferential redemption rights were offered to all existing investors and such rights will continue to be offered to all future investors (without qualifications such as minimum commitments, etc.).
• Advisers are not allowed to provide preferential information rights about investments or exposures unless that information is also offered to all other investors at the same time (or substantially the same time).

Disclosures required for other preferential treatment:

Other than the items noted above, it’s important to keep in mind that the new rules do not prohibit side letters for preferential terms, per se. In fact, advisers can continue to offer them to specific investors — but only if they also provide certain disclosures.

• The adviser must provide written notice to prospective investors related to all material economic terms, including, but not limited to, the cost of investing, liquidity rights, fee breaks, and co-investment rights.
• The adviser must also provide written notice to all current investors of all preferential treatment offered to other investors. This must be provided for:
  • Liquid funds: As soon as reasonable following the investor’s investment in the fund, and at least on an annual basis thereafter.
  • Illiquid funds: As soon as reasonable following the end of the fundraising period and annually thereafter.

For many fund advisers, complying with these side-letter obligations will require substantial investment in their internal and external investor-relations processes, technology, and people in order to communicate with investors efficiently. Similarly, they may need to upgrade their compliance function to enable those professionals to effectively monitor and document their disclosure activities.

Recordkeeping obligations: Advisers should ensure that they keep (a) books and records to support their compliance with the preferential treatment rule (i.e., a copy of the written notices sent to current and prospective investors), (b) a record of each addressee, and (c) the date the documents were sent.

Annual Compliance Reviews

The Rule requires all RIAs to annually (at minimum) review their compliance policies and procedures and then document such reviews.

Bottom line

Overall, the new rules represent a step forward in enhancing transparency for private fund investors and providing the many benefits of increased information sharing. However, private fund advisers need to approach their growing compliance necessities strategically and holistically in order to mitigate rising costs that might be passed on to limited partners – which would only serve to negate some of the benefits of increased transparency. The advisers that begin planning now with a clear vision of the long-term impact of these changes will be able to best position themselves to minimize complexity and costs and perhaps gain a competitive advantage in the hunt for new investors.

Work with us 

^{1. Per the Rule, the information must be in plain English, in a tabular format, that has been organized in a consistent and concise manner.}

^{2. Advisers should always ensure that all fees and expenses that are charged to the fund are permitted under their respective offering and organizational documents.}

^{3. Defined as (a) officers, partners, directors, employees of the adviser, (b) persons directly or indirectly controlled by the adviser, and (c) any persons under common control with the adviser. Control is the power to direct (either directly or indirectly) the management or policies whether through ownership or contract. These definitions are consistent with the definitions used for Form ADV and Form PF.}

^{4. An illiquid fund is defined as a private fund that (a) is not required to redeem interests upon an investor’s request, and (b) has limited opportunities, if any, for investors to withdraw prior to the termination of the fund. Therefore, a liquid fund is any fund that is not defined as an illiquid fund.}

^{5. Gross IRR is defined as an internal rate of return that is calculated gross of all fees, expenses, and performance-based compensation borne by the private fund. Net IRR is calculated net of all fees, expenses, and performance-based compensation borne by the private fund.}

^{6. Gross MOIC is defined as multiple of invested capital that is calculated gross of all fees, expenses, and performance-based compensation borne by the private fund. Net MOIC is calculated net of all fees, expenses, and performance-based compensation borne by the private fund.}

^{7. Defined as any subscription facilities, subscription line financing, capital call facilities, capital commitment facilities, bridge lines, or other indebtedness incurred by the fund that it secured by its unfunded commitments from its investors.}

^{8. Defined as a person that provides fairness opinions or valuation opinions in the ordinary course of its business and is not a related party of the adviser.}

^{9. Defined as a written solicitation distributed by, or on behalf of, the adviser or any related party requesting private fund investors to make a binding election to participate in an adviser-led secondary transaction.}

^{10. For purposes of requesting consent under this Rule, advisers generally should list each category of fee or expense as a separate line item, rather than group fund expenses into broad categories, and describe how each such fee or expense is related to the relevant investigation.}

^{11. The SEC has not provided specific terms, but it could include the amount, interest rate, repayment schedule, etc.}

The information provided here is for general guidance only, and does not constitute the provision of tax advice, accounting services, investment advice, legal advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers.