SEC Rule Changes for Private Fund Advisers – What are the implications on non-U.S. private fund managers and investors?

Overview

On 23 August 2023, in a sweeping reform, the U.S. Securities and Exchange Commission (the SEC) adopted a number of amendments to the rules (each such amendment, a New Rule, and collectively the Rules) promulgated under the Investment Advisers Act of 1940, as amended (the Advisers Act), which would significantly modify the regulatory obligations of advisers of private funds. Please see here for the Rules.

We expect the Rules to reshape the regulatory landscape and best practices for the private funds industry, both within the U.S. and globally. Although the Rules are not applicable to non-U.S. offshore private fund advisers (i.e., fund managers organised under the laws of a non-U.S. jurisdiction with principal office and place of business outside the U.S.) (non-U.S. advisers) with respect to their non-U.S. private fund clients (i.e., private funds organised under the laws of a non-U.S. jurisdiction and operated outside the U.S.) (non-U.S. private funds), regardless of whether such non-U.S. funds have U.S. investors, we recommend such non-U.S. advisers and their fund investors to familiarise themselves with the Rules, and consider whether their existing policies and operational protocols would need to be reviewed and updated.

The Commission is adopting carefully tailored rules to address certain practices that may impose significant risks and harms on investors and private funds. The reforms are designed to protect those who directly or indirectly invest in private funds by increasing visibility into certain practices, establishing requirements to address practices that have the potential to lead to investor harm, and prohibiting or restricting adviser activity that is contrary to the public interest and the protection of investors.” – SEC

Overview of the Rules

Rules which are applicable to SEC-registered U.S. private fund advisers and SEC-registered non-U.S. advisers with respect to their U.S. private fund clients

1. Quarterly Statement Rule

What is the New Rule about at a glance?

To enhance transparency, an adviser is required to provide investors with quarterly statements detailing certain information regarding fees, expenses and performance of its private funds.

Key details [1]

The fees and expenses disclosures include:
- a detailed accounting of all compensation, fees, and other amounts allocated or paid to the adviser or any of its related persons by the private fund during the reporting period;
- a detailed accounting of all fees and expenses allocated to or paid by the private fund during the reporting period other than those listed in the item above; and
- the amount of any offsets or rebates carried forward during the reporting period to subsequent quarterly periods to reduce payments or allocations to the adviser or its related persons.
Performance disclosures include:
- For liquid funds: performance based on net total return on an annual basis for the 10 fiscal years prior to the quarterly statement or since the fund’s inception (whichever is shorter), over 1-, 5-, and 10-fiscal year periods, and on a cumulative basis for the current fiscal year as of the end of the most recent fiscal quarter.
- For illiquid funds: performance based on internal rates of return and multiples of invested capital since inception and to present a statement of contributions and distributions.

We have only extracted some of the key details of each New Rule for the purposes of an overview for this article. Please refer to the SEC’s official publication of the Rules here for full details.

Legacy status: Not available.

Compliance date: 14 March 2025.

2. Annual Audits Rule

What is the New Rule about at a glance?

An adviser is required to conduct annual financial statement audits of its private funds.

Key details

An adviser is required to obtain an annual financial statement audit of the private funds it advises, directly or indirectly. The audit should meet the “custody rule” requirements in the Advisers Act, and is subject to other requirements (e.g., the auditor should meet certain independence criteria, the audited financial statements should be prepared in accordance with U.S. GAAP, etc.).

Legacy status: Not available.

Compliance date: 14 March 2025.

3. Adviser-Led Secondaries Rule

What is the New Rule about at a glance?

An adviser is required to obtain either a fairness opinion or valuation opinion in relation to an adviser-led secondary transaction [2].

An “adviser-led secondary transaction” means a transaction initiated by the SEC-registered adviser that offers fund investors the option between selling all or a portion of their interests in the private fund and converting or exchanging them for new interests in another vehicle advised by the adviser or any of its related persons.

Key details

An adviser is required to obtain either a fairness opinion or a valuation opinion from an independent opinion provider who meets certain expertise and independence criteria in relation to any adviser-led secondary transaction involving a private fund where such adviser acts as investment adviser.

Legacy status: Not available.

Compliance date: 14 March 2025.

Rules which are applicable to all (1) U.S. private fund advisers and (2) non-U.S. advisers with respect to their private funds domiciled in the U.S. (regardless of whether or not they are SEC-registered or exempt)

4. Preferential Treatment Rule

What is the New Rule about at a glance?

To better protect investors, this New Rule prohibits an adviser from providing investors with preferential treatment regarding redemptions and information regarding the portfolio holdings or exposures of the fund if the adviser reasonably expects such treatment would have a material, negative effect on other investors.

In all other cases of preferential treatment, the SEC adopted a disclosure-based exception to the proposed prohibition, including a requirement to provide specific disclosure regarding preferential terms to all existing and prospective investors.

These written disclosure obligations can be complied with either by providing copies of side letters with preferential terms to all investors in the fund (with identifying information regarding the other investors redacted) or a written summary of the preferential terms with sufficient and specific details.

Key details

Prohibitions aspect of the New Rule

An adviser is prohibited from granting an investor in the private fund or a similar pool of assets [3] the ability to redeem its interests on terms that the adviser reasonably expects to have a material, negative effect on other investors.
- Two exceptions:
  - the ability to redeem is required by applicable law; or
  - the adviser offers the same ability to redeem to all existing and future investors in the private fund or a similar pool of assets.
An adviser is also prohibited from providing information regarding the portfolio holdings or exposures of the private fund or a similar pool of assets to any investor in that fund if the adviser reasonably expects that providing this information would have a material, negative effect on other investors.
- Exception: the adviser offers such information to all other existing investors in the private fund or a similar pool of assets at the same or substantially the same time.

Disclosure portions of the New Rule

An adviser is prohibited from providing other types of preferential treatment to an investor in a private fund, unless sufficient written disclosure is provided to all existing and prospective investors:
- For current investors:
  - Extent of disclosure: all preferential treatment (including those unrelated to material economic terms) the adviser has provided to other investors in that fund.
  - Timing of disclosure: as soon as reasonably practicable following the investor’s investment in the fund (for liquid funds) or the end of the fund’s fundraising period (for closed-end funds).
- For prospective investors:
  - Extent of disclosure: preferential treatment relating to any material economic terms.
  - Timing of disclosure: prior to the investor’s investment.
Further, an adviser is required to provide an annual written notice to existing investors, in which specific information regarding any preferential treatment which has been provided to other investors in the fund since the last notice (if any) should be included. For example, the mere disclosure of the fact that other investors are paying lower fees is insufficient – the disclosure must describe the lower fee terms, including the applicable rate, in order to provide specific information as required by the New Rule.

A “similar pool of assets” means a pooled investment vehicle (apart from a registered investment company, a business development company that has elected to be regulated as an investment company, or a securitised asset pool) that has “substantially similar investment policies, objectives or strategies” to those of the relevant private fund. This may include co-investing funds, parallel funds, feeder funds, etc. which align with the definition outlined.

Legacy status:

Available under the prohibitions aspect of the Preferential Treatment Rule, which prohibits advisers from providing certain preferential redemption rights and information about portfolio holdings.
Not available to the disclosure portions of the Preferential Treatment Rule. As a result, information in side letters that existed before the compliance date will be disclosed to other investors that invest in the fund post compliance date.

Compliance date:

For larger private fund advisers [4]: 14 September 2024.
For smaller private fund advisers [5]: 14 March 2025.

5. Restricted Activities Rule

What is the New Rule about at a glance?

This New Rule will restrict certain other adviser activities which are contrary to the public interest and the protection of investors.

An adviser generally will not be prohibited from engaging in certain restricted activities, as long as it provides appropriate specified disclosure and, in some cases, obtains investor consent.

“Larger private fund advisers” means advisers with private fund AUM of US$1.5 billion or more calculated as of the last day of such adviser’s most recently completed financial year.

“Smaller private fund advisers” means advisers with private fund AUM of less than US$1.5 billion calculated as of the last day of such adviser’s most recently completed financial year.

Key details

Restricted activities subject to disclosure-based exceptions include:

Charging or allocating any regulatory, compliance or examination fees and expenses of the adviser to the fund.
- Disclosure exception requirement: notify the investors in writing of any regulatory, compliance or examination fees or expenses on a quarterly basis at minimum, if such fees or costs are to be charged or allocated to the private fund.
Reducing any “adviser clawback” obligation (i.e. an obligation to reimburse any performance-based compensation in accordance with the fund’s governing documents) by the amount of any actual, potential or hypothetical taxes applicable to the adviser, its related persons, or their respective owners or interest holders.
- Disclosure exception requirement: notify the investors in writing of the aggregate dollar amount of the adviser clawback both before and after any such reduction for actual, potential or hypothetical taxes, within 45 days after the end of the fiscal quarter in which the adviser clawback occurs.
Charging or allocating fees and/or expenses related to a portfolio investment on a non-pro-rata basis when there are multiple vehicles or clients advised by the same adviser or its affiliates investing in the same portfolio investment
- Two requirements must be met:
  - the non-pro rata allocation must be fair and equitable under the circumstances; and
  - before charging or allocating such fees and expenses to the fund, the adviser must notify each investor in that fund in writing of the non-pro rata charge or allocation and a description of how it is fair and equitable under the circumstances.

Restricted activities subject to consent-based exceptions include:

Charging or allocating to the private fund any fees or expenses associated with the investigation of the adviser or its related persons by any governmental or regulatory authority, except that charging or allocating fees or expenses arising from sanctions imposed for violating the Advisers Act or rules promulgated thereunder are flatly prohibited.
- Consent exception requirement: obtain written consent from at least a majority in interest of the fund’s investors that are not related persons of the adviser.
Borrowing, directly or indirectly, money, securities or other fund assets (or otherwise receiving a loan or extension of credit) from a private fund client.
- Consent exception requirement: notify the investors in writing of the borrowing and describe the material terms [6] and obtain written consent from at least a majority in interest of the fund’s investors that are not related persons of the adviser.

The phrase “material terms” is intentionally not defined by the SEC, but the SEC indicated they could include the amount of money to be borrowed, interest rate and the repayment schedule, depending on the facts and circumstances.

Legacy status:

Not available to restricted activities subject to disclosure-based exceptions.
Available to restricted activities subject to consent-based exceptions.

Compliance date:

For larger private fund advisers: 14 September 2024.
For smaller private fund advisers: 14 March 2025.

What are the implications of the Rules on non-U.S. advisers?

For non-U.S. advisers, depending on whether they are SEC-registered or SEC-exempt, some of the Rules may be applicable to their U.S. organised private funds. If they are SEC-registered, they are subject to all the Rules 1 to 5 outlined above; if they are SEC-exempt, they are subject to the Rules 4 to 5 outlined above.

However, the Rules are not applicable to non-U.S. advisers with respect to their non-U.S. private funds, regardless of whether such funds have U.S. investors. Nonetheless, we believe it is crucial for non-U.S. advisers to become familiarised with the Rules for the following reasons.

What are the implications of the Rules on investors of U.S. or non-U.S. private funds?

All U.S. private fund advisers with AUM above certain minimum thresholds are subject to the Rules with respect to all their private funds; whereas non-U.S. advisers are generally not subject to the Rules with respect to their non-U.S. private funds. Investors investing in or looking to invest in private funds managed by U.S. advisers or U.S. organised funds managed by non-U.S. advisers should be aware of the rights and benefits afforded to them under the Rules and be ready to safeguard their interests by requesting that such rights and benefits be reflected in the fund documentation.

In particular, we expect the Preferential Treatment Rule (see New Rule 4 above) to fundamentally alter the current market practice of closed-end private funds in one significant aspect – the most favoured nations (MFN) treatment.

The Preferential Treatment Rule requires private fund advisers to:

disclose to current investors all preferential treatment which has been provided to other investors in the fund, as soon as reasonably practicable following the investor’s investment in the fund (for liquid funds) or the end of the fund’s fundraising period (for closed-end funds);
disclose to prospective investors preferential treatment relating to any material economic terms, prior to the investor’s investment; and
provide an annual written notice to existing investors, which should include specific information regarding any preferential treatment which has been provided to other investors in the same fund.

The SEC has indicated that the rationale behind the Preferential Treatment Rule is to increase transparency to better inform smaller investors about the extent of preferential treatment provided to investors with greater bargaining power, the potential for those terms to affect their investment in private funds, and the potential costs (including compliance costs) associated thereof. The SEC believes these new disclosure requirements are consistent with the intent of the anti-fraud provisions of the federal securities law and will further the goal of protecting investors against harms they may suffer unwittingly in their investments in private funds.

Extent of disclosure

Under the typical MFN practice currently, an investor with the benefit of the MFN treatment is entitled to review and elect the rights or benefits contained in the side letters of other investors, subject to certain carve-outs. The MFN treatment is usually subject to certain carve-outs, such as:

appointment of limited partner advisory committee representatives (which is usually reserved for larger or first-close investors);
specific tax and regulatory requirements (which are only applicable to specific investors due to their individual circumstances);
excuse rights (which may be due to individual investors’ compliance reasons, especially for multilateral development banks and development financial institutions which are subject to a range of policies and directives); and
special management fee discounts (which are usually granted to first-close investors due to their early support for the fund and to investors with larger ticket size).

The application of the Preferential Treatment Rule would require:

For existing investors – all preferential treatment provided to other investors in the fund to be disclosed to the existing investors.
For prospective investors – preferential treatment relating to any material economic terms provided to existing investors to be disclosed to the prospective investors.

The SEC has broadly defined “material economic terms” as the terms that a prospective investor would find most important and would significantly impact its bargaining position, and has specified that cost of investing, liquidity rights, fee breaks and co-investment rights are “material economic terms”. The SEC also explained that co-investment rights will generally qualify as a material, economic term to the extent they include materially different fee and expense terms from those of the main fund (e.g. no fees or no obligation to bear broken deal expenses). However, we note that, even if co-investment rights do not include different fee and expense terms, investors often negotiate for those rights and give up other terms in the bargaining process in order to secure access to co-investment opportunities because they often provide an investor with additional exposure to a particular investment or investment type. Therefore, co-investment rights should be generally treated as a “material economic term” subject to the new disclosure requirements. The SEC also pointed out that excuse rights would be a kind of preferential treatment.

Investors should review and where necessary, update their existing template side letter requests in order to align with the Preferential Treatment Rule. For example, certain MFN carve-outs may no longer be accepted by the private fund advisers, if the advisers take the view that they are contradictory to the Rules.

Timing of disclosure

In the current MFN practice of a closed-end fund, investors are usually entitled to elect the rights or benefits after the end of the fund’s fundraising period, whereas open-end fund investors are typically entitled to elect these rights or benefits after the closing of their investment. Further, MFN provisions may be time-based, where the side letter terms of investors in the first closing of a fund are not disclosed to (and not electable by) investors in subsequent closings.

Under the Preferential Treatment Rule, advanced disclosure of preferential treatment relating to any material economic terms to prospective investors is required. The SEC believes that it is crucial for prospective investors to have access to certain information before they invest, and this New Rule is designed to prevent investors from being misled because it will provide them with transparency regarding how the terms may affect their investment, how the terms may affect the adviser’s relationship with the private fund and its investors, and whether the terms create any additional conflicts of interests.

This may be great news for any investors looking to come into any subsequent closing of a fund. However, on the other hand, first-close investors may lose any time-based MFN advantages typically granted to them due to their early support for the fund. Nevertheless, the existing investors will be informed of all preferential treatment provided to the other investors as soon as reasonably practicable after the fundraising period of the fund under the Preferential Treatment Rule, which means to the extent a fund provides MFN treatments based on closings, it is expected that investors from earlier closings will request a modification right to their MFN treatment based on what they subsequently learn about the MFN benefits received by investors of subsequent closings. Further, it is expected that this New Rule will enable investors to protect their interests more effectively and make more informed investment decisions with a broader understanding of market terms, including with respect to negotiations of new investments or renegotiations with the same fund manager.

During the compliance period, investors are encouraged to review and update their current practices and standard requests to reflect the development of the Rules, in order to ensure their rights are adequately captured under the relevant protocols and can be readily applied in future fund investments.

Latest development

On 1 September 2023, a group of six U.S. trade associations representing the private funds industry commenced litigation against the SEC [7], claiming that the Rules are unlawful and harmful to the industry. In their lawsuit, the group asked the court to vacate the Rules, asserting that the SEC had overstepped its statutory authority under the Advisers Act and acted in contradiction to the SEC’s mission to maintain a fair, orderly and efficient capital market, and facilitate capital formation.

Please let us know if you have any questions. We would be delighted to help.

The lawsuit was filed by the Managed Funds Association, National Association of Private Fund Managers, National Venture Capital Association, American Investment Council, Alternative Investment Management Association and the Loan Syndications & Trading Association.