Introduction
On February 9, 2022, the Securities and Exchange Commission voted to propose new rules to “enhance” the regulation of private fund advisers by increasing “transparency, competition, and efficiency.[1] The proposed rules were not entirely unexpected, but their substance and implications appeared to target the fundamental elements of the private funds and disrupt the relationships with investors. Specifically, the proposal included prohibitions for private fund advisers, whether registered with the SEC or not, “from providing certain types of preferential treatment to investors in their funds and all other preferential treatment unless it is disclosed to current and prospective investors.”[2]
The Proposal’s War on Side Letters and Most Favored Nations Clause
This statement though benign on its face, is a direct assault to the heart and soul of the private funds’ contractual relationship with their investors via “Side Letters” and the Most Favored Nations Clauses (“MFN”). The use of side letters by private funds has become ubiquitous since they modify the terms of the governing partnership agreement and typically are memorialized in a letter executed by the fund’s General Partner. Side Letters have always been viewed as an “inducement” for potential investing Limited Partners since it grants them special rights and privileges, including early exits and redemptions, lower management and performance fees and in some cases, ad hoc reporting. The Side Letter usually is reserved for investors who are willing to make large capital commitments and the General Partner usually is more than willing to accommodate.
It’s not completely one-sided since the accommodations may be advantageous to other Limited Partners. Many prospective Limited Partners will negotiate for a MFN provision that permits the election of certain benefits negotiated by, and granted to, other limited partners via a Side Letter. The prospective Limited Partner will ask for the best deal; i.e., they want the most preferential terms already handed by Side Letter to other Limited Partners.
Comment Letters Reflected Varying Perspectives
The Comments Letters[3] received on this proposal were voluminous and varied. Over a hundred letters were received and were divided in several factions; United State Senators and Representatives strongly supported the new rules and hailed them as “reforms,” while the Attorneys General of several states[4] derided the proposals because, “these rules impose burdensome requirements on regulated companies and will ultimately harm investors and all Americans.”[5] The Fund industry opinioned through comment letters submitted by the Institutional Limited Partners Association arguing that Limited Partners are “sophisticated investors” and can negotiate for themselves, and the GPs say the rules are unnecessary.”[6] Following these comments, letters were submitted by State and Union Pension Funds, Law School Professors, Funds and a fair number of investors.
Taking these varying views into consideration, the SEC staff released the New Private Fund Rule on August 23, 2023.
In this month’s Risk Management Tip, we will explore the reforms that are triggered by the New Private Fund Rule. We believe that these changes will have a profound impact on the day-to-day operations of Private Fund Advisers. We will summarize the requirements as set forth by the Rule, and set forth the effective date for each of these areas.
Summary of the New Private Fund Rule
Quarterly Statements: Rule 211(h)(1)-2
Requires registered private fund advisers to provide investors with quarterly statements including information about fund performance, fees, and expenses. The quarterly statements must include a Fund table that includes all compensation and fees provided to the Adviser and fees and expenses paid by the Fund.
Effective Date: 18 months after date of publication in the Federal Register.
Private Fund Audit Rule: Rule 206(4)-10
Requires a registered private fund adviser to obtain an annual audit of the financial statements of any private fund it manages and to distribute them to investors in the private fund promptly after completion of the audit. The audit would need to be performed by an independent accountant registered with the Public Company Accounting Oversight Board. The Audit Rule a written agreement between the adviser or the private fund and the auditor, pursuant to which the auditor would be required to notify the SEC’s Division of Examinations upon the auditor’s termination or issuance of a modified opinion (Auditor Notification Requirement).
Effective Date: 18 months after date of publication in the Federal Register.
Prohibited Activities: Rule 211(h)2-1
This Rule prohibits an investment adviser to a private fund, directly or indirectly, from engaging in certain activities with respect to the private fund or any investor in that private fund, including: charging certain fees and expenses to the fund including accelerated monitoring fees; fees or expenses associated with an examination or investigation of the adviser or its related persons by governmental or regulatory authorities and borrowing money, securities, or other fund assets, or receiving an extension of credit, from a private fund client.
The Rule’s most controversial provision prohibits agreements with limited partners that contain language Seeking reimbursement, indemnification, exculpation, or limitation of its liability by the private fund or its investors for a breach of fiduciary duty, willful misfeasance, bad faith, negligence, or recklessness in providing services to the private fund.
Effective Date: 12 months after date of publication in the Federal Register.
Secondary Transaction Fairness/Valuation Opinion: Rule 211(h)2-2
Requires registered private fund advisers, in connection with an adviser-led secondary transaction, to obtain and distribute to investors a fairness opinion or a valuation opinion and a written summary of certain material relationships between the adviser and the opinion provider. The SEC reasons that this Rule is designed to provide an important check against an adviser’s conflicts of interest in structuring and leading a transaction from which it may stand to profit at the expense of private fund investors.
Effective Date: 12 months after date of publication in the Federal Register.
The No “Side letters” or “Preferential Treatment”: Rule 211(h)(2)-3
Prohibits a private fund adviser from side letters that offer redemption terms that “may have a material, negative effect on other investors” and providing reporting and information that the other Fund investors may not receive. The SEC wants a level playing field for all investors and the Rule states we are “prohibiting advisers from providing preferential treatment to any investor in a private fund” unless the adviser provides written disclosures to prospective and current investors in the private fund regarding all preferential treatment the adviser or its related persons provided to other investors in the same fund.
Effective Date: 12 months after date of publication in the Federal Register.
Annual Review: Rule 206(4)-7(b)
Requires all registered advisers, including those that do not advise private funds, to document the annual review of their compliance policies and procedures in writing. The Rule does not enumerate specific elements that advisers must include in the written documentation of their annual review. This SEC guidance does comport with their principle-based rule system, though advisers, we believe, may be more careful as to the content of their reviews or try to classify as attorney-client privilege to shield it from closer regulatory scrutiny.
Effective Date: 60 days after date of publication in the Federal Register.
Conclusion
Advisers (registered or not) need to review these new rules and their current Policies and Procedures to determine the impact on their firms. Advisers considering forming new Private Funds should incorporate these Rules for their new offering. Most of the rules are effective between 12 – 18 months of being published in the Federal register, however, special consideration should be given to the Annual Review Rule which becomes effective 60 days after the date of publication in the Federal Register. Exempt Reporting Advisers (“ERAs”) and other unregistered advisers are not affected by the Quarterly Statement Rule, the Private Fund Audit Rule, the Adviser-Led Secondaries Rule, or the Compliance Rule Amendment.
Jacko Law Group provides counsel to private fund advisers and can assist in performing your Annual Review. For more information and to explore how the new Private Fund Rule will impact your organization, please call us at 619.298.2880.
[1] https://www.sec.gov/news/press-release/2022-19.
[2] Ibid.
[3] Comments on Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Review, https://www.sec.gov/comments/s7-03-22/s70322.htm.
[4] The States of Montana, Louisiana, Alabama, Mississippi, Alaska, Ohio, Arizona, Oklahoma, Arkansas, South Carolina, Georgia, South Dakota, Indiana, Texas, Kansas, Utah. Kentucky, and West Virgina signed the October 24. 2022 comment letter.
[5] https://www.sec.gov/comments/s7-32-10/s73210-20147444-313668.pdf.
[6] https://www.sec.gov/comments/s7-26-22/s72622-20165136-334499.pdf