Regulation of Investment Advisers Under the Final New Private Funds Rules Adopted by the SEC

By Elliot Weiss

Investment advisers play a pivotal role in providing investor guidance and managing assets; a particularly important role given the complexity of the financial markets. Depending upon circumstances, investment advisers may interact with investors either directly or indirectly through a number of complex entity forms, all the while regulated by the Securities and Exchange Commission (SEC), which has established a comprehensive framework to regulate investment advisers under the Investment Advisers Act of 1940 and investment companies and funds under the Investment Company Act of 1940.

More recently, the SEC has adopted new private fund rules—this under the Investment Advisers Act—aiming to enhance transparency and investor protection of private fund advisers. Those rules are examined here. But first, some context.

What Are Private Funds?

Private funds are typically not available to the general public and cater to a more limited number of accredited investors. These are pooled investment vehicles excluded from the definition of investment company under sections 3(c)(1) and 3(c)(7) of the Investment Company Act. Examples include hedge funds, private equity funds, and venture capital funds.

Historically, many private funds were exempt from registering with the SEC due to the applicable "private adviser exemption" under the Investment Advisers Act allowing certain advisers with fewer than 15 clients to avoid registration. However, this exemption was supplanted by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which set forth new exemptions for advisers. Now, only those advising exclusively to venture capital funds or solely to private funds with less than $150 million in assets under management in the U.S. are exempt from registration requirements.

The net effect of the Dodd-Frank Act: many previously unregistered advisers to private funds must register with the SEC or the states.

Private Fund Regulation

In recent years, the SEC recognized the need to enhance oversight of private funds and address potential systemic risks arising from their operations. This led to the adoption of rules contemplating all of the following:

1. Form PF: Form PF (Private Fund) mandates registered investment advisers to private funds to provide detailed information about their funds' assets, strategies, leverage, and

counterparty exposures—data that enhances the SEC's ability to monitor systemic risks and potential market vulnerabilities stemming from private funds. SEC-registered investment advisers with at least $150 million in private funds under management use Form PF to report, on a non-public basis, information about the private funds that they manage, including fund type (hedge fund or private equity), size, and liquidity.

2. Liquidity Risk Management Program: SEC Rule 22e-4 requires open-end funds, including mutual funds and some ETFs, to implement a comprehensive liquidity risk management program. This ensures that funds maintain a sufficient level of liquidity to meet investor redemptions during times of market stress.

3. Reporting Modernization: Also in place are reporting requirements for regulated investment companies and ETFs to provide investors with more accurate and timely information about fund holdings, risk exposures, and performance, all in an effort to promote greater transparency and enable investors to make informed decisions.

New Private Funds Rules

The need to bolster investor protection beyond that provided for in the aforementioned rules led the SEC—last month—to approve final rules and amendments to the Investment Advisers Act. These new rules, which further enhance protections afforded investors in private funds managed by private fund advisers, impact not just SEC-registered investment advisers, but also exempt reporting advisers, state-registered investment advisers, and other unregistered investment advisers.

A. Restrictions on Conflicted Activities

The new private funds rules impose restrictions on certain conflicted activities that investment advisers may engage in, particularly concerning fees, expenses, and clawbacks. Conflicts of interest can undermine investors' trust and compromise the integrity of the investment management process. The SEC's regulations aim to mitigate these conflicts and promote greater alignment between investment advisers and their clients.

1. Fees and Expenses. Investment advisers are now subject to new restrictions on charging or allocating certain fees and expenses to the funds they manage. Restricted activities include (i) charging or allocating fees and expenses associated with any regulatory, compliance or examination fees or expenses of the adviser or its affiliates; (ii) charging or allocating fees associated with an investigation of the adviser or its affiliates by any governmental or regulatory authority; (iii) charging or allocating fees and expenses related to an investigation of the adviser or its affiliates that results or has resulted in a court or governmental authority imposing a sanction for a violation of the Investment Advisers Act or the rules promulgated thereunder; and (iv) charging or allocating fees and expenses related to a portfolio investment on a non-pro rata basis when more than one private fund or other client advised by the adviser or its related persons have invested in

the same portfolio company. Some of these restricted activities may be authorized with informed consent and/or subsequent or advanced disclosure while other are prohibited outright. The goal here is to prevent advisers from allocating excessive or unjustified fees to funds, ensuring that investor returns are not unduly diminished by such practices.

2. Borrowing or receiving an extension of credit from a private fund client. Investment advisers are now subject to new restrictions on borrowing money, securities or other private fund assets, or receiving loans, or extensions of credit, from private fund clients. When seeking to borrow from a private fund client, investment advisers are required to obtain informed consent and accompany such consent with explicit disclosure of the material terms of the borrowing to the client.

3. Reduction of Clawbacks. The new rules also restrict an adviser from reducing the amount of any performance, compensation clawback (e.g., clawback of carried interest, performance allocations, etc.) by actual, potential or hypothetical taxes applicable to the adviser, its affiliates or their respective owners or interest holders. The restrictions here can be waived in the event the adviser subsequently discloses to investors the aggregate amount of the clawback both before and after the clawback reduction.

For conflicted activities to be waived, the adviser must provide appropriate disclosures and, under certain circumstances, informed consent, which must be obtained from at least a majority of investors unrelated to the adviser.

B. Prohibitions on Preferential Treatment and Increased Transparency

The new rules introduce prohibitions on providing certain investors with privileges or advantages that are not extended to other investors (a practice frequently seen in the use of side letters, side arrangements and more favorable liquidity terms provided in a fund's governing documents with respect to preferred investors). These prohibitions relate to:

1. Redemptions. Investment advisers are now prohibited from granting preferential treatment to specific investors concerning redemptions; specifically, advisers cannot provide an investor in a private fund or in a similar pool of assets the ability to redeem an interest on terms that the adviser reasonably expects to have a material, negative effect on other investors.

2. Information. Similar to redemptions, the new rules prohibit preferential treatment in terms of information dissemination regarding portfolio holdings or exposures of a private fund, or of a similar pool of assets, to any investor 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 similar pool of assets. Investment advisers must ensure that all investors have access to the same information, preventing information asymmetries that could be exploited by certain investors to gain unfair advantages.

C. Enhanced Transparency and Accountability

For SEC-registered investment advisers to private funds, the new rules further require them to furnish detailed quarterly statements to investors. The statements encompass a comprehensive array of critical information such as performance, fees and expenses, and adviser and adviser-related compensation.

In addition, SEC-registered private fund advisers are now subject to enhanced annual audit mandates that require them to conduct more comprehensive and rigorous annual audits of their private funds. Among other things, they must obtain an annual financial statement audit of the covered private funds they advise.

Finally, the new private funds rules include requirements related to adviser-led secondary transactions (e.g., any transaction initiated by an adviser or its affiliate that offers fund investors the option between selling all or a portion of their interests in a private fund and converting or exchanging them for new interests in another vehicle advised by the adviser or any of its related persons). SEC-registered investment advisers engaging in these transactions must obtain fairness or valuation opinions for adviser-led secondary transactions and written summaries of any material business relationships between advisers or their affiliates and the independent opinion providers within a specified time frame.

In Conclusion

The new private funds rules— set to go effective 60 days after publication in the Federal Register—mark a significant step towards enhancing investor protection, transparency, and fairness within the private funds sector. Likewise, they represent a substantial expansion of the SEC’s regulation of private fund advisers that are sure to have a significant impact on future SEC examination and enforcement activities. That being said, it is expected that private fund advisers will have 12 to 18 months (depending on the rule) following the date of publication in the Federal Register to become compliant with the new private rules.

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations.