The SEC’s Recent Proposed Reforms for Private Funds May Impose a Significant Burden for Private Fund Managers and Investors
The U.S. Securities and Exchange Commission (the “SEC”) has been intensely focused on the private investment funds industry in recent years. On February 9, 2022, the SEC announced proposed new rules under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), aggressively targeting private investment funds and their managers.
The proposed reforms appear to be designed to protect sophisticated investors rather than retail investors. The proposed reforms are intended to increase an investor’s visibility into certain private fund practices and prohibit activity that may be contrary to the public interest, in the interest of investor protection. However, in our view, the proposed reforms appear to interfere with privately negotiated terms between private fund managers and a class of sophisticated investors that are generally capable of fending for themselves without significant interference from the SEC.
The proposed reforms, as described below, should be expected to pose a significant operational burden to private fund managers. This burden will likely increase the overall costs that managers and/or investors will ultimately need to fund as a result of the enhanced costs associated with modifying offering documents and compliance with the ongoing reporting requirements.
New Quarterly Statement Rule
The proposed reforms would require registered private fund managers to distribute a quarterly statement to private fund investors with a detailed accounting of all fees and expenses paid by the private fund during each relevant reporting period. Moreover, the new statement requirements would require disclosure of information regarding the compensation or other amounts paid by the private fund’s portfolio investments to the manager or any of its related persons or entities.
The proposed reforms also would require managers to provide information regarding the private fund’s performance. For “liquid funds” (as defined in the proposed reforms), the quarterly statement would generally have to provide the following: annual net total returns since inception, average annual net total returns over prescribed time periods, and quarterly net total returns for the current calendar year. For “illiquid funds” (as defined in the proposed reforms), the statement would generally have to provide the following: the gross and net internal rate of return, and the gross and net multiple of invested capital for the illiquid fund to capture performance from the fund’s inception through the end of the current calendar quarter.
Takeaway: Private fund managers will have to review their current reporting requirements and the services and reporting they are currently receiving from their fund administrators and/or other service providers to determine if they can comply with the new quarterly statement requirements. It is likely that detailing additional information on a quarterly basis about a private fund’s performance, fees, expenses, and returns will increase the costs of the fund administrator, and those costs will likely be ultimately passed onto the investors in the private fund. To the extent applicable, fund manager will need to re-negotiate their administration agreements.
New Audit Rule
The proposed reforms would require registered private fund managers to cause the private funds they advise to undergo a financial statement audit, at least annually and upon liquidation. The SEC is also seeking comments on whether or not it should require unregistered managers or managers that are exempt reporting advisers to cause the private funds they advise to undergo a financial statement audit. The SEC contends that audits: (x) provide an important check on the manager’s valuation of private fund assets, which often serve as the basis for the calculation of the manager’s fees, and (y) protect private fund investors against misappropriation of fund assets. While most registered managers may already be subject to financial statement requirements pursuant to the “custody rule” exemption under the Advisers Act, the proposed reforms would also result in additional requirements for the auditor of the fund to report any qualification of the financial statements or the termination of the auditor to the SEC. In addition, it is important to note that there is no “surprise audit” alternative in the proposed new rule.
Takeaway: Fund managers would need to review their auditor engagement terms to ensure that they comply with the new requirements.
New Manager-Led Secondary Transaction Rule
The proposed reforms would also require a registered private fund manager to obtain a fairness opinion in connection with a manager-led or an adviser-led secondary transaction. In these transactions, managers often offer existing fund investors the option to sell or exchange their interests in the private fund for interests in another vehicle advised by the same manager. An independent opinion provider would have to opine on the fairness of the price being offered to the private fund for any assets being sold as part of the transaction. This proposal also would require the manager to prepare and distribute to the private fund investors a summary of any material business relationships the independent opinion provider has or has had within the past two (2) years with such manager or any of its related persons.
Takeaway: This requirement is likely to provide a check against certain conflicts of interest in structuring and leading a transaction from which a manager may stand to profit at the expense of private fund investors; however, it will also increase the costs of such transactions, and many sophisticated investors may likely feel that the expense of an independent fairness opinion will be unnecessary, costly and intrusive to their private negotiations with private fund managers.
New Prohibited Activities Rule
The proposed reforms would also prohibit all private fund managers from engaging in certain activities and practices that the SEC believes may be contrary to the public interest and the protection of investors.
These practices include the following:
prohibiting from charging certain fees and expenses to a private fund or its portfolio investments, such as fees for unperformed services (e.g., monitoring, servicing, consulting or other fees, as well as accelerated monitoring fees)—however, note that the manager may still receive fees for services actually rendered or where there is an offset for such fees;
prohibiting or severely reducing the ability to charge fees for certain regulatory matters (e.g., (x) fees associated with an examination or investigation of the manager or its affiliates by a governmental agency or regulatory authority, and/or (y) regulatory and compliance fees);
limiting or eliminating the ability to seek reimbursement, indemnification, exculpation, or limitation of its liability for a breach of fiduciary duty, willful malfeasance, bad faith, negligence or recklessness in providing services to the private fund—note that most fund documents accepted in today’s marketplace typically do not allow a manager or its affiliates to be indemnified or exculpated from liability in the event of “gross negligence”; the proposed prohibition from seeking indemnification or limitation of liability in the event of simple “negligence” would be a radical change in the private funds landscape and the treatment of fund managers;
reducing the amount of any clawback for the manager by the amount of certain taxes—note that, as of today, such clawback is a widely accepted term in most private equity fund documents;
prohibiting from charging certain fees or expenses related to a portfolio investment on a non-pro rata basis; and
prohibiting form borrowing or receiving an extension of credit from a private fund client.
The SEC contends that prohibiting the above practices would address conflicts of interest that, if not addressed, could reasonably lead to fraud and investor harm because they incentivize a manager to place its interests ahead of the private fund’s interests.
Takeaway: This new reform would force managers to review their existing offering documents and revise such documents, in a timely manner, to reconcile existing terms that have already been negotiated with their investors and may be accepted standards in the industry. Again, investors in private funds are likely to bear the expense of the legal fees related to the revisions associated with this aspect of the new reform.
New Preferential Treatment Rule
The proposed reforms would also prohibit all private fund managers from providing preferential terms to certain investors regarding: (x) withdrawals from a fund or (y) information about portfolio holdings or exposures if the adviser reasonably expects that providing such information would have a material negative impact on other investors in the fund or in a substantially similar asset pool. This is intended to prevent treating portfolio holdings information as a commodity. It also would prohibit all private fund managers from providing other preferential treatment unless disclosed to current and prospective investors. Specifically, the proposed reforms would require managers to: (x) describe the preferential treatment in sufficient detail or (y) provide copies of side letters to all potential and then-current investors.
Takeaway: This new reform would force managers to review their existing side letters and similar agreements and may potentially even harm investors that have already negotiated preferred terms.
New Books and Records Rules and Annual Compliance Amendment
The proposed reforms also include amendments to the “books-and-records rule” under the Advisers Act that require managers to retain records related to the proposed reforms. The amendments would facilitate the SEC’s ability to assess a manager’s compliance with the proposed reforms. Moreover, the proposed reforms include amendments to the annual compliance rule under the Advisers Act that require all registered managers, including those that do not advise private funds, to document their annual review in writing.
Takeaway: Maintaining additional records and documenting an annual compliance review will increase the compliance burden on, and require the expenditure of additional resources by, managers.
Certain General Observations
In general, the proposed reforms, if adopted, would change the private funds industry from a negotiations-based landscape to a more regulated landscape, essentially (x) uprooting decades-long practices and standards with regard to negotiated terms and disclosure documentation, and (y) imposing additional costs and administrative burdens, directly and/or indirectly, on various parties in the private funds industry. It is important to note that the proposed reforms do not contain any “grandfathering” provisions, thereby further complicating a manager’s compliance obligations—this is especially true for managers of private equity funds and similar vehicles where withdrawals of investors, if necessary, may not be easily accomplished. If the rule is adopted, all managers will have to comply within one (1) year of the date of adoption of the final rule.
Looking Ahead
In sum, the above proposed reforms, if adopted, are expected to have a material impact on managers and investors alike. For example, the expense of re-drafting existing offering documents, Form ADV disclosures and/or side letter agreements, while protecting investors, may expose them to high expenses associated with such updates, thereby potentially outweighing the benefits. In addition, some managers may think twice about going into, or staying in, the private investment management business in light of the additional burdens of these new requirements, thereby potentially leaving investors with fewer investment choices.
Please contact us with any questions on these proposed reforms or any other questions you may have. A public comment period will remain open for the proposed reforms for sixty (60) days following publication on the SEC’s website on February 9, 2022, or thirty (30) days following publication of the proposing releases in the Federal Register, whichever is longer.
The foregoing proposed reforms may not necessarily be adopted in their current proposed form. Various industry groups are monitoring these developments, and we will keep you informed in the coming weeks and months.
If you have any questions about this alert, or any other matters, do not hesitate to reach out to:
Yehuda Braunstein (Partner - Head of the Family Office group) at 212.573.8029 or via ybraunstein@sadis.com Ron Geffner (Partner - Head of the Financial Services group) at 212.573.6660 or via rgeffner@sadis.com Yelena Maltser (Partner - Financial Services & Corporate groups) at 212.573.8429 or via ymaltser@sadis.com Daniel Viola (Partner – Head of the Regulatory group) at 212.573.8038 or via email at dviola@sadis.com
