The Securities and Exchange Commission approved a private fund advisor rule on Wednesday that makes sweeping changes to the $20 trillion industry — including a provision requiring all registered investment advisors to document in writing the annual review of their compliance policies and procedures.
Commissioner Hester Peirce, who voted against the rule, expressed concern during the vote on Wednesday that the provision affecting all advisors was “tucked away” in a private fund advisors release.
Still, the new rule — which walked back some of the more contested provisions included in the February 2022 rule proposal — passed with a 3-2 majority with supporting votes cast by SEC Chairman Gary Gensler, Commissioner Caroline Crenshaw, Commissioner Jamie Lizarraga, and opposing votes by Commissioner Peirce and Commissioner Mark Uyeda.
Brian Forman, a lawyer with Morrison Cohen that represents private fund managers, told RIA Intel that although there was no official requirement for advisors to document the review process prior to this rule, it is common practice and something he always recommends that his clients do to better prepare for exams.
More broadly, Chairman Gensler said in the meeting that the new rule addresses potential conflicts, provides investors greater transparency, and benefits market transparency.
“Today’s final rule I really do believe will promote efficiency, competition, integrity, and transparency in this space of investment advisors advising private funds. That’s good for investors, that’s good for issuers, [and] it’s good for market alike,” Gensler said.
In addition to the provisions affecting all registered advisors, the rule set out specific requirements for private equity managers, hedge funds, and other advisors offering private funds.
According to the new rule, all private fund advisors registered with the SEC are required to provide investors with quarterly financial information on fund performance, fees, and expenses. It also requires them to obtain an annual audit for each private fund and obtain a fairness opinion or valuation opinion from an independent provider in connection with any secondary transactions led by the fund’s general partner.
Jeff Leathers, co-founder of Tap, a secondary private fund trading platform founded in 2021, said that he was surprised this last provision made it into the final rule. “Fairness opinions are quite burdensome because the cost of getting a fairness opinion is quite high,” he said. “I don’t imagine that it will have a significant adverse effect on GP-led transactions, which have been growing very quickly over the past years. But I do imagine that it will add a bit of cost and time to the process as it currently stands.”
Forman, on the other hand, said that he already advises all his clients to get fairness opinions because it’s protective for them.
“When you do a deal like that, you’re essentially taking an asset from one fund that you manage and selling it to another fund that you manage. You can imagine how significant the conflict of interest is there,” he said.
The SEC rule will also subject all private fund advisors — not just those registered with the SEC — to a list of restricted activities that prohibit them from engaging in certain practices that are “contrary to the public interest and the protection of investors” unless advisors provide disclosures to investors, and in some cases, receive investor consent.
Funds will still be allowed to charge limited partners a fee till tied to regulatory or compliance issues, as long as it’s disclosed and isn’t tied to an SEC investigation. The SEC also dropped an earlier provision that would have made it easier for investors to sue funds for misconduct.
As part of the new rules, advisors will also need to disclose any type of preferential treatment, such as terms included in side letters, that materially benefits one investor at the expense of another, and offer those same terms to all of the investors in the fund.
Side letters are a common industry practice that are typically required by early, strategic investors who provide initial capital to a fund in exchange for special rights — typically fee breaks — in connection with their investment, said Forman.
“It’s going to be a huge, huge mess for people to deal with. I think that determining which provisions you need to offer to all investors, based on whether those provisions materially impact one investor versus another, is going to be a subjective analysis that the industry is going to have a really hard time getting its arms around,” said Forman. He also thinks it might have a chilling effect on the industry, particularly smaller GPs.
“They might view this as such a hurdle in terms of the expense associated with their client obligations, and also their ability to raise capital from essentially seed investors by not being able to give them preferential terms, that it could very well create some significant barriers to entry,” he said.
Leathers said that overall, the side letter rule makes a lot of sense. “I think it brings a lot more transparency into the market and it’s one of the first examples of really the SEC providing regulation over the sort of private contracts that folks are signing in these private markets, which may be a harbinger of things to come in terms of increased regulation of private market space as they get larger.”
The rules go into effect in 60 days and will only affect new deals. Existing contracts will not have to be rewritten. Advisors will need to be in compliance with the Private Fund Audit Rule and Quarterly Statement Rule 18 months after the date of publication in the Federal Register. The compliance date for the Adviser-Led Secondaries Rule, the Preferential Treatment Rule, and the Restricted Activities Rule varies based on the advisor’s AUM. Advisors managing $1.5 billion or more in private fund assets have 12 months to be in compliance, while advisors with less than $1.5 billion in private fund assets have 18 months.
