What the SEC's new rules mean for private funds

September 5, 2023

SEC regulators voted on August 23 to approve new rules for asset managers, including private equity and venture capital firms. The changes are widely regarded as the largest updates to the rules affecting private fund managers that are not SEC-registered investment advisers since Dodd-Frank in 2010.

Under the new rules, private fund advisors registered with the SEC must provide their investors quarterly statements that include fund-level fees, expenses paid by the fund, certain compensation and other money paid to the fund company, and performance. Investment advisors offering private funds must also get an annual audit for each private fund it advises and distribute it to its investors. Asset managers will also be required to provide a valuation opinion for adviser-led secondary transactions.

The rules forbid private fund advisors from giving preferential treatment to certain investors unless they offer the same terms to other current and prospective investors in a fund. The rules also barred preferential treatment for some investors that might have a material negative effect on others. For example, giving some investors a heads up on information so they could seek redemptions before other investors.

The rules go into effect within 60 days from August 23rd, the day the committee voted to approve them. Funds will have 18 months from the effective date to comply with the quarterly statement and audit rules, and advisors will have at least 12 months to comply with the secondaries, preferential treatment, and other rules.

We spoke to Michael Wu, Partner at Winston Strawn in its fund services practice, and Greg Larkin, Partner at Goodwin Proctor’s Financial Industry group and Private Investment Funds practice, about what these changes mean for fund managers.

Why has the SEC adopted these new rules?

Michael Wu: “The SEC does routine examinations on registered investment advisors, and if they identify recurring themes that they view as issues for investors, they’ll first put together guidelines then ultimately a rule to address those issues. Some of the issues they're looking at are investor protections, and a lot of that relates to lack of information, lack of the ability to negotiate, and potentially treating some investors differently to others. So if you're a smaller investor, you don't get the same benefits as someone who’s larger.

They also see that the number of funds has grown significantly over the last 10 years. Around 70,000 new funds have been formed and the total AUM increased to a much larger amount. The SEC recognizes that this is getting to be a large industry and they need to address it. 

The number of VC funds has increased 3x in the last five years, and they tend to be much smaller than private equity hedge or real estate funds. When you have smaller funds, you often target more accredited or retail plus investors, and these are the investors that are likely to need some protection from the regulators. 

SEC’s chairman, Chairman Gensler, has been active and the SEC has adopted a lot of new rules over the last couple of years.  I think ultimately, he's aiming to fix the issues the SEC has seen over the last 10 years or so, and that's really why these things are coming into play.”

Greg Larkin: “The principal goal of the Private Funds Rules is to change the balance of power in investor negotiations to make private fund terms more “investor friendly”, particularly with respect to fees and expenses. 

The new rules aim to level the playing field by providing more disclosure on the fees and expenses being charged by private funds and restricting the ability to charge or allocate certain categories of fees and expenses. For example, with respect to government investigations. The regulator is also attempting to offer investors more specificity and transparency on the preferential treatment being provided to some LPs. 

The objective is to create greater competition among private fund sponsors on fees and expenses, similar to what has occurred in the mutual fund space. Longer term, this aims to drive fees and expenses down for investors.”

How will the new rules impact fund operations? 

MW: “Many in the industry were pleasantly surprised to see that the SEC took a less heavy-handed approach and instead of prohibiting all the things that they stated they were going to prohibit, it became more of a disclosure plus consent requirement. For example, they removed the part that changed the standard of indemnification from everything that you're typically seeing into just simple negligence.

The biggest implication would be on side letters. Under the new rules, fund managers have to disclose all side letter provisions that they’re entering into. For instance, maybe there's a fee waiver or discount to get people in the door, which the fund manager will now have to disclose to all investors. 

Practically, fund managers will have to carefully manage the language that is going into those side letters. However, larger LPs often have internal counsel that insist on certain language and want it set up based on their form template. We would steer our clients to create that side letter template and have all their LPs conform to it, which avoids a lot of risks that come from having four different side letters with three different confidentiality provisions, and having to disclose all three.

I'd also recommend funds to have one provision that addresses as much as possible. That’s the confidentiality provision, and maybe a fee discount.Essentially, manage the process so you don't have 50 different side letter provisions. You have to disclose it, but you don't have to allow everyone to elect into it. 

GL: “There are a few different aspects of the Private Funds Rules that could have a material impact on fund operations.  

First, SEC-registered advisers will need to start providing quarterly statements with details on fees and expenses and with partially standardized performance. Operationally, they’ll need to set up the systems to decide on fee and expense categories, allocate the fees and expenses into these categories each quarter, and ensure the accuracy of the allocations. 

They’ll also need to update their performance reporting protocols to satisfy the requirements in the Private Funds Rules and related guidance. This quarterly process should also include whether they are relying on the notice exceptions for regulatory, compliance and exam fees and expenses; or reducing the adviser clawback for taxes. Fund managers will also need to deliver quarterly statements and/or notices in accordance with the SEC electronic delivery requirements.

In addition, the fee and expense allocation policies and procedures will need to be updated to reflect the allocations for fees and expenses in the quarterly statements as I discussed above, and also for the restriction on non-pro rata allocations of fees and expenses.

Finally, any private fund that is not relying on the annual audit exception under the Custody Rule for example, relying on the surprise examination approach or the adviser does not have “custody”, will need to start being audited in accordance with the new Audit Rule.”

What do you think the long-term industry impact of the new rules will be?

MW: “When the proposed rules came out, I think the whole industry was up in arms. So the fact that there's a grandfather provision, like what they refer to as a legacy fund, I think that's going to be helpful in the transition. 

But with all things, including Dodd-Frank, these new rules come in, the industry adapts, and then it's business as usual. If you're a registered investment advisor, there are going to be additional costs because you have these additional requirements and reporting. The vast majority of VC funds that aren’t registered investment advisers will not be impacted as much.”

GL: “The long-term impact is difficult to predict. As I said before, the SEC would like to see increased downward pressure on fees and expenses, but it’s unclear if providing detailed reporting on fees and expenses will lead to that. However, it may be that there are certain expenses that the advisers stop charging funds either because the cost of complying with the exception is too difficult—for instance, non pro rata allocations, or regulatory and compliance expenses of the adviser—or because the adviser doesn’t want to disclose the amount in the quarterly statements. The formalization of the quarterly fee and expense allocation process may also lead to advisers being more conservative on what is charged to fund and/or an easier way for the SEC to bring enforcement actions for mistakes in the allocation process.

In addition, the SEC would like to see less preferential treatment to larger institutional investors.  It’s also not clear that this will happen—aside from with respect to redemption rights—since smaller investors will be unlikely to have the negotiating power to get better treatment even if they’re aware of the specifics of the terms for the larger investors. There may be more standardization among the treatment of larger investors since they’re more likely to be able to bargain for better terms based on the knowledge that other larger investors have gotten better terms. However, some of that already occurs in the MFN process.

Although nominally aimed at reporting to existing investors in the funds, it seems likely that some of the required practices will bleed into marketing materials since, for example, the adviser may not want to have multiple versions of performance presentations. It seems likely that prospective investors will request to see the quarterly statements of existing funds.

Finally, there’s the more general point of whether the SEC’s position in the Private Funds Rules with respect to an adviser’s fiduciary duty and what is misleading. Outside of the context of the Private Funds Rules, the SEC may require increased specificity on material conflicts. The SEC also heavily criticized LPACs, which may lead to pressure for advisers to seek investor consent and not rely on LPACs for getting consent to conflicts of interest.”

Read more about the new rules in the SEC’s official announcement.


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