SEC’s Private Fund Adviser Rules: Tackling the Dos, Don’ts, and Maybes

The US Securities and Exchange Commission’s new rules for private fund advisers are meant to increase transparency for investors, but they will also increase operational pain and cost for compliance managers even more, fund executives tell FinOps Report.

Although the SEC has eliminated some of the more controversial provisions for the estimated US$22.6 trillion dollar industry initially proposed in 2022, fund managers will still have plenty of cumbersome changes to digest in the form of dos, don’ts and maybes. Although no compliance director who spoke with FinOps Report wanted to quantify the additional compliance expense, all dozen from hedge funds and private equity funds  hope that either some or all of the rules will eventually be overturned. “The problem with following the rules is that in some cases they are subject to interpretation which will require speaking with outside counsel on an ongoing basis,” one compliance director at an East Coast hedge fund management shop tells FinOps Report. None of the compliance managers believe the SEC has proven there is a need for new rules. Instead, they say, the regulatory agency has created a solution in search of a problem.

On September 1 of this year, six trade associations asked the Fifth Circuit Court of Appeals in New Orleans to overturn the SEC’s rules by May 31, 2024. The plaintiffs, which include the Loan Syndications and Trading Association and the Managed Funds Association, are basing their lawsuit on three factors. The SEC has no statutory authority to implement the new rules, the new provisions are arbitrary; and the regulatory agency didn’t seek further comment after the rules were altered to take industry feedback into consideration.

Some attorneys familiar with the case, but unrelated to the plaintiffs, believe the plaintiffs have the best chance of succeeding based on the fact that the SEC did not follow administrative law when it avoided further industry feedback after it made major changes to the rules when first proposed. However, based on court documentation, the plaintiffs appear to be betting on the SEC’s overstepping its legal bounds. The trade groups argue that Congress has recognized that private funds do not require extensive regulatory requirements based on the size and sophistication of investors. Current regulations do not provide a basis for the SEC’s new sweeping regulations over private funds.

In the meantime, compliance directors at private fund management firms will find themselves plagued with a forest of paperwork and analysis to handle based on the premise that the rules must be followed unless the Fifth Circuit Court decides otherwise. US hedge fund managers, fund of fund managers, and private equity fund managers will be impacted in varying degrees by the new rules which take effect in a phased approach from twelve to eighteen months after they were published in the Federal Register in early September. The exception to the timeline is the provision to create a written annual review of compliance policy which takes effect 60 days after the rules’ publication. That provision applies to all registered fund advisers– not just private funds.

Legacy funds– those created before the effective dates — could be exempt from complying with some of the provisions of the new rules. All non-US private fund advisers whose principal office is outside the US will not have to follow the new rules even if they have US investors; the only exception is for the annual review of compliance requirement. Non-US private fund advisers must follow all of the rules for US-domiciled funds, while securitized asset fund advisers are generally exempt from the new rules.

“Once fund managers have determined the scope of how the rules apply to their firms, they need to determine what updates are needed to comply with the rules and based on that analysis update their written compliance policies and procedures,” says Amber Allen, general counsel of Raleigh NC-based Fairview, a compliance administration and investment administration firm. “Compliance manuals, fund documents, and Form ADV disclosures need to align and be updated to reflect any changes required under the new rules.” Allen, who presented her views in a recent podcast alongside the law firm of Troutman Pepper, also recommends that sales managers be educated on the new provisions, so they don’t rely on the wrong terms and agreements. “It’s really important that the entire team is aware of the upcoming changes, any changes in documentation, and that the firm has a thorough plan for future fund launches,” she says.

One of the most controversial new requirements involves generating a detailed quarterly statement which must be distributed to all investors by 45 days at the end of each quarter and 90 days at the end of each fiscal year. Although fund managers may have previously provided reports on how they are spending investors’ monies, such reports were typically done on a consolidated basis. The SEC now wants quarterly statements with organizational, accounting, legal, tax, due diligence, and travel expenses broken down in a table. In addition, each quarterly report must contain a separate table on the fees and other compensation paid to fund managers and related parties before and after the application of any offsets, rebates or waivers.

When it comes to disclosing fund performance, there will be two options– one for liquid funds and another for illiquid funds. Hedge funds would likely fall into the category of liquid funds, while private equity funds would likely be categorized as illiquid funds. Registered investment advisers for liquid funds would need to reveal net total return on an annual basis for ten fiscal years prior to the new quarterly statement since the fund’s inception– whichever is shorter. Registered investment advisers for illiquid funds would need to disclose since their inception, with and without the impact of subscriptions, the gross and net internal rate of return; the gross and net multiple of invested capital; and the gross internal rate of return and gross multiple of invested capital.

The operations, accounting, and compliance departments of private fund advisers along with their fund administrators will be involved with finding the data and making the calculations to produce the new quarterly reports. The compliance departments must then sign off on the quarterly statement and the investor relations departments will be left to answer questions from investors who might not understand what the numbers mean or want explanations as to why they are at certain levels. “Private fund managers seeking institutional investment already provide significant disclosure, but the detailed information and standardized formats will be difficult to handle for small to mid-sized firms with less automation than their larger peers,” says Daniel Bresler, a partner in the law firm of Seward & Kissel in New York. The challenge of fulfilling the quarterly report requirement is compounded for fund of funds advisers which must aggregate information from multiple underlying funds. They have 75 days at the end of the first three quarters and 120 days at the end of each fiscal year to do so.

In addition to ensuring accurate and detailed quarterly reports, private fund advisers must also be aware of the interplay between the SEC’s private fund adviser rules and its marketing rule. “If a quarterly statement is used for marketing purposes, as in a pitch book, then an independent analysis would need to be done to determine compliance with the marketing rule,” says Genna Garver, a partner at the law firm of Troutman Pepper in New York who spoke at the podcast hosted by her firm. “Where an analysis will get more complicated is if an adviser wants to use the quarterly statement in addition to other performance figures in marketing.” What then? The firm would need to be very cautious about determining what disclosures would need to be added and if policies would need to be updated, says Garver. Effective May 2021, the SEC’s marketing rule consolidates and modernizes the rules governing the advertising and cash solicitation practices of investment advisers which are registered or must register. Advisers had to be compliant by November 2022.

Another element of the SEC’s proposal for private fund investors which will prove difficult to follow is in the category of don’ts for fund managers. All private fund managers– registered and unregistered– cannot give certain types of preferential treatment to some investors without offering the same terms to other investors.  For example, private fund managers are not allowed to give preferential redemption terms to certain investors unless such preferential terms are required by law, or such preferential terms are offered to all investors in the private fund or a similar pool of assets without qualification. In addition, private fund managers are not permitted to give preferential access to information on the fund or the fund’s investments unless such preferential access is offered to all investors in the private fund or a similar pool of assets at the same time or substantially the same time.

In its adopting release about the new rules, the SEC defines a similar pool of assets as an investment vehicle, other than a registered investment company, with substantially similar investment policies, objectives or strategies to those of the private fund that is managed by the adviser or its related parties. However, the SEC does not provide much guidance on how to interpret the same time or substantially the same time. Such a lack of clarity means navigating one-to-one discussions or bespoke reporting, according to Fairview’s Allen. “That [process] is going to be a challenge and will require a lot of documentation.” As a result, she believes, some advisers may have to do a lot of planning to stick to script when having one-on-one discussions with investors.

The intertwined issues of preferential redemption and preferential access to information are particularly relevant to hedge funds and other open-ended funds. For example, if an adviser provides preferential redemption terms and preferential access information about a hedge fund’s holdings to only one investor, that investor may use negative information about the fund gained from the preferential access to information and use its preferential redemption right to redeem out of the fund ahead of other investors.

Compliance with certain preferential treatment rules for private fund advisers will be more painful than others. “With respect to the provision of information to a large investor that is not provided to  the fund’s other investors, the investment adviser will have to carefully analyze whether the distribution of such information will have a material negative effect on other investors in the fund or similar pool of assets,” says Joseph Suh, a partner in the law firm of Reed Smith in New York. “This analysis will require the investment adviser to consult outside legal counsel, which will add to the adviser’s compliance costs.” Even so, simply rejecting requests from investors for preferential treatment regarding redemptions and information may not be an option. The largest institutional investors, such as pension systems, may not invest without such preferential terms.

Even preferential terms that are not related to redemptions or access to information will give private fund advisers a case of angina. The rules also include terms which require disclosure only and terms which require disclosure and consent from investors. “The private fund adviser cannot provide preferential treatment related to any material economic terms to some investors without disclosure before the investment is made,” says Seward & Kissel’s Bresler. Material economic terms include terms that will impact an investor’s bargaining power such as the cost of investing, liquidity rights, and fee breaks.

One provision of required consent under the new rules is that private fund advisers cannot allocate to a private fund fees and expenses related to an investigation of an adviser or its related persons by any governmental agency without the agreement of a majority of interest of fund investors that are not related persons to the adviser. However, even with consent a fund adviser cannot allocate fund fees and expenses to a fund if the investigation leads to a sanction. If the fund adviser does allocate the fees and expenses but ends up with a sanction it would have to reimburse investors the full amount. Private fund advisers also cannot borrow money or securities from investors without obtaining permission from a majority of interest of fund investors that are not related persons to the adviser. The SEC does not specify the types of borrowing which must be disclosed but at a minimum it is the material terms such as the amount of the borrowing, the interest rate, and the repayment schedule.

For all affected private fund managers concerned about how to address the new SEC requirements, outside compliance consultants, fund administrators and fund counsel will help but the use of such service providers will materially increase the managers’ external compliance costs. Internal compliance cost will also rise.  “Although fund administrators, compliance consultants and legal counsel can assist, the burden of compliance will be highest for compliance officers and investor relations officers in terms of additional time and effort they will need to spend to deal with the new rules,” says Reed Smith’s Suh. Smaller fund advisers may opt to outsource the role of chief compliance officer, while larger ones will likely retain the role in-house.

Now is the time to apply the three Ps of budget management for 2024, say compliance managers who spoke with FinOps Report. Those are — prepare to ask the finance department for more money; pray the request is approved; and plan for what to do if it isn’t.