Increasing scrutiny on private fund advisers

A Sea Change for Private Fund Advisers is on the Horizon

Regulation of investment advisers, including private fund advisers, has significantly increased over time.

Recent rules proposed by the SEC in February 2022 represent the most significant sweeping proposed rule reforms since 2012 and these proposed rules came on the heels of the SEC’s observations from recent private fund adviser exams. SEC Chairman Gensler has repeatedly and publicly voiced his concerns around the private fund industry and the need to improve investor protection and increase transparency.

The most significant observation from the proposed rule changes is that many of the proposed rules reach any private fund adviser, whether or not registered or required to be registered. While implementation of the proposed rules will take several months and are likely to incorporate a transition period for fund compliance, private fund advisers who want to ride the wave rather than get sucked under are smart to stay on top of the proposals and begin aligning their structures and disclosures toward compliance with the new rules.

Common Themes and Proposed Rules

According to the SEC, approximately 35% of all SEC-registered advisers manage approximately $18 trillion in assets. In just 5 short years, the assets managed have grown 70%. Given this magnitude, it is no wonder the SEC is laser-focused on regulation to provide what they believe is adequate investor protection. At a high level, the deficiencies noted in the Staff’s 2022 alert included: conduct that was inconsistent with investor disclosures, misleading performance information coupled with a lack of supporting documentation, investment due diligence and waivers of adviser liability. Last year, the SEC had been focused on fees and expenses, conflicts of interest and policies around material non-public information. It is therefore no surprise that on the heels of outlining the 2022 deficiencies and factoring in the focus of the SEC last year, the proposed rules outlined by the SEC can be categorized into direct prohibitions on certain activities and increased disclosure requirements. As noted, certain of the proposed rules would apply to registered advisers while other proposed rules would apply to all private fund advisors.

Direct Prohibitions on Certain Activities

The rules around direct prohibitions on activities apply to all private fund advisers and include prohibitions on:

Charging certain fees and expenses to a fund or its portfolio investments, such as fees for unperformed services (e.g., accelerated monitoring fees) and expenses associated with an SEC examination or investment of the adviser or even regulatory and compliance expenses of an adviser;

Seeking reimbursement, indemnification, exculpation or limitation of liability for an adviser’s breach of their fiduciary duty, willful malfeasance, bad faith, negligence or recklessness;

Reducing the clawback by the amount of certain taxes;

Charging fees or expenses related to a portfolio investment on a non-pro rata basis when multiple funds have invested in the same portfolio investment;

Borrowing or receiving an extension of credit from a private fund; and

Engaging in certain types of preferential treatment that have a material negative effect on other investors while also prohibiting all other types of preferential treatment unless disclosed to current and prospective investors.

Increased Disclosure Requirements

The proposed rules around disclosure requirements apply to all SEC-registered advisers and include:

Providing investors with quarterly statements detailing information about fund performance, fees and expenses, as well as adviser compensation;

Obtaining an annual audit for each fund and causing the fund’s auditor to notify the SEC upon certain events (such as termination of the auditor’s engagement);

In connection with an adviser-led secondary transaction, distribution of a fairness opinion to investors and a written summary of material business relationships between the adviser and the provider of the opinion;

Documenting the annual compliance review in writing;

Adopting and implementing policies designed to address cybersecurity risks;

Requiring the report of significant cybersecurity incidents to the SEC on a confidential basis; and

Enhancing overall disclosure around cybersecurity risks and incidents.

Riding the Wave of Change

Regulation of private fund advisers is nothing new, but the recent proposed rules from the SEC represent significantly increased attention to the regulation of private funds – a focus that is likely to reduce economics, increase compliance costs and ratchet up scrutiny on private investment fund advisers. While it can be expected that these proposed rules will receive significant comments, it is also expected that the SEC will adopt some form of the outlined rules even if slightly modified to accommodate comments. As such, those private fund advisers who are apprised of recent rule proposals and aim to comply on a faster timeline are sure to have a better shot at riding the wave of change.