The biggest change to regulation since 2012 - the SEC's new private fund rule

In February 2022, the SEC proposed a new rule on private fund advisers which, given the numerous changes proposed (across 342 pages!) collectively represents an enormous update to the regulators' requirements for the alternative asset industry. Indeed, this is likely the biggest change since the 2012 rules which made registration mandatory, not optional, for hedge and private markets managers. After 18 months of discussion, the rule will now be voted on next week So what are the changes as proposed?

1) Quarterly statements
Every Registered Investment Adviser must, within 45 days of quarter end, deliver a formal statement to the investors in every private fund they manage (a "private" fund in SEC terminology represents a fund which is not registered under the 1940 Act (i.e. a public / mutual fund) - that means a hedge fund, private equity fund, private credit fund and, where the adviser is registered, real estate and VC structures). 

Fee and expense disclosures: for every fund, the asset manager must disclose:

(i) the manager's own compensation including management, incentive and any other fees paid to the manager. This includes any fees received directly by the officers and partners of the management company - this captures items such as directors fees and other fee income from portfolio companies;

(ii) a detailed accounting of all fees and expenses paid by the fund that quarter, with a separate line for each item. The categories which must be disclosed include organizational, accounting, legal, administration, audit, tax, due diligence and travel expenses. It is interesting to see that the SEC explicitly forbids reporting based on "grouping of fund expenses into broad categories" - instead, the SEC is forcing consistent, granular disclosure of the expenses which are paid by fund investors; and

(iii) any offsets, rebates and waivers.

In addition, the manager must disclose any fees paid by underlying portfolio companies to the adviser or their employees, and disclose fees paid to the manager such as "origination, management, consulting, monitoring, servicing, transaction, administrative, advisory, closing, disposition, directors, trustees" or similar fees and payments.

Finally, categories and types of expenses must be cross referenced to the fund prospectus / LPA to show how the fees which have been charged are permitted (and have been previously disclosed).

Performance disclosure:

Within 45 days of each quarter end, the manager must present performance for the quarter and since inception plus over one, five and ten year calendar periods. Private markets funds must show performance based on Internal Rate of Return (IRR) and Multiple of Invested Capital (MOIC), and include additional information about contributions and distributions from the fund and realized / unrealized positions.

The rule explicitly requires private equity and other private market funds to present IRR ignoring the impact of any delays in capital calls facilitated by a subscription credit line. The SEC notes that "these 'levered' performance figures often do not reflect the fund's actual performance and have the potential to mislead investors."

2) Mandatory Private Fund Audits: every hedge / private market fund must be audited, in accordance with GAAP. (Yes there are funds which are not audited, and there are funds which report on non GAAP basis such as income tax basis or based on the terms of the limited partnership agreement).

3) Adviser Led Secondaries. Managers - which will primarily impact the PE space - will be required to obtain a fairness opinion if they offer their investors the chance to sell their interests in the private fund, or to exchange them for interests in a another vehicle. (This would apply, for example, to continuation vehicles and similar restructurings when assets cannot be sold within the original proposed life of the fund).

The fairness opinion will be "a written opinion that the price being offered to the private fund for any assets being sold as part of an adviser-led secondary transaction is fair". In addition, this fairness opinion must be delivered to the manager / fund by an "independent opinion provider" who is not related to the adviser and provides opinions in the normal course of their business. The SEC explicitly want to ensure that the opinion provider has the "expertise to value illiquid and esoteric assets based on relevant criteria".

4) Prohibited Activity: Fees for Unperformed Services. Managers will be prohibited from charging investors (either directly through the fund or via fees charged to underlying portfolio companies) for services which were not performed. This explicitly prohibits the practice of "accelerated monitoring fees", which were the subject of numerous SEC enforcement actions in 2014/15 which really kick started the Commissions' attention to practices in the private equity space.

5) Prohibited Activity: Charging the fund for fees and expenses associated with an examination or investigation of the adviser or its related persons by any governmental or regulatory authority.

6) Prohibited Activity: Charging the fund for regulatory or compliance fees and expenses of the the adviser and its related persons - even where such fees and expenses are otherwise disclosed. The SEC specifically notes that compliance is a cost "related to forming and operating an advisory business and this should be borne by the adviser and its owners rather than the private fund and its investors."

7) Prohibited Activity: Reducing Adviser Clawbacks for Taxes. If a fund pays an interim incentive fee on initially successful investments, (more likely to arise in a PE fund with an American style, deal by deal waterfall rather than a European 'whole fund' waterfall) but then performance slumps as later investments turn out to be loss making, most PE funds have a "clawback" provision. The SEC will ensure that investors receive the full value of the clawback based on the fees they paid to the manager - and not have that amount reduced by the "actual, potential or hypothetical taxes applicable to the adviser, its related persons, or their respective owners or interest holders."

8) Prohibited Activity: Limiting or Eliminating Liability for Adviser Misconduct. A manager will not be able to be indemnified (or reimbursed, exculpated etc) against a breach of fiduciary duty, willful malfeasance, bad faith, negligence or recklessness in providing services. This is a material change, as most fund lawyers write documents so that the manager is indemnified for negligence and only provide liability in the event of gross negligence. As one example, trade errors would now be charged to the management company, not the fund - this will be a material change as compared to offering documents which, in 2023, often provide that the manager is only responsible for the cost of a trade error if it was a result of their gross negligence.

9) Prohibited Activity: Non Pro Rata Allocation of Fees and Expenses on Actual or Potential Investments. Notably, this will prevent a manager charging 100% of broken deal fees to the fund, even if the proposed deal envisaged co-investors investing alongside the fund (e.g. a $2bn acquisition is proposed of which $250m would be from the flagship fund and $1.75bn from a pool of sovereign wealth funds / large pension investors who have co-investment capacity). At present, co-investors frequently avoid these fees, with all of the costs of a failed deal falling to fund investors. Per the SEC: "because the other client would receive the benefit of any upside in the event the transaction goes through, we believe that such client should also generally bear the burden of any downside in the event the transaction does not go through".

10) Prohibited Activity: Borrowing. A manager will not be able to directly or indirectly borrow money, securities, other fund assets or receive a loan or an extension of credit from a private fund client. It is interesting to note that this is an area where the SEC pushes back on the LPAC concept of private markets fund governance: "Even when disclosed (and potentially consented to by an advisory board, such as an LPAC), this practice presents a conflict of interest that is harmful to investors because, as a result of the unique structure of these funds, only certain investors with specific information or governance rights (such as representation on the LPAC) would potentially be in a position to negotiate or discuss the terms of the borrowing with the adviser, rather than all of the private fund's investors".

11) Prohibited Activity: Preferential Redemptions. The SEC will prevent managers offering large investors special terms via side letter or other structure (which includes through creation of  funds of one and parallel structures for large investors) the ability to redeem on "terms that the adviser reasonably expects to have a material, negative effect on other investors in that private fund or in a substantially similar pool of assets". 

12) Prohibited Activity: Preferential Transparency. Similarly, the SEC will prevent managers from giving favoured investors "information regarding the portfolio holdings or exposures of the private fund or of a substantially similar pool of assets to any investors if the adviser reasonably expects that providing the information would have a material, negative effect on other investors in that private fund or in a substantially similar pool of assets". Per the SEC - "selective disclosure of portfolio holdings or exposures can result in profits or avoidance of losses among those who were privy to the information beforehand at the expense of investors who did not benefit from such transparency. In addition, such information could enable an investor to trade in portfolio holdings in a way that 'front-runs' or otherwise disadvantages the fund or other clients of the adviser."

13) Disclosure of all preferential (i.e. side letter) terms. The SEC will require funds to list all material side letter terms, including any deals related to matters such as fee breaks, capacity rights, co-investment rights etc. The detail required is significant: "An adviser would need to describe specifically the preferential treatment to convey its relevance. For example, if an adviser provides an investor with lower fee terms in exchange for a significantly higher capital contribution than paid by others, we do not believe that mere disclosure that some investors pay a lower fee is specific enough. Instead, we believe an adviser must describe the lower fee terms, including the applicable rate (or range of rates if multiple investors pay such lower fees)".

Collectively, the SEC has addressed numerous issues encountered - especially during operational due diligence - across both public market hedge funds and private market (PE, venture, infra, real estate, private credit) funds.  

We expect that some of the proposed rules will be changed or removed from the final text - we will have the final version in a week!