On February 9, 2022, the SEC proposed the “Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews” reform that could have a significant impact on investment advisers and the private funds they manage.
Annual Audits, Quarterly Statements, and other Additional Requirements
The intent of this reform is to enhance investor protection under the Investment Advisers Act of 1940 by requiring the following:
- Annual audits of private funds: Registered private fund advisers would need to obtain an audited set of financial statements from a Public Company Accounting Oversite Board (PCAOB) registered firm. The auditor would also be required to notify the SEC upon the issuance of a modified opinion as well as their resignation, dismissal, or termination from an engagement (the notification must be within 4 days). Additionally, the auditor is required to notify the SEC if they decline to be re-engaged by the investment adviser to perform the audit (the notification also must be within 4 days).
- Quarterly statements: Registered private fund advisers would need to issue quarterly statements within 45 days of the quarter’s end to investors detailing:
- Fund performance: For liquid funds, annual net returns for every calendar year are required from inception, average annual returns for one, five, and ten calendar year periods, and the cumulative net return for the calendar quarter. For illiquid funds, an internal rate of return (IRR) and multiple of invested capital (MOIC), including IRR and MOIC bifurcated between realized and unrealized gain/loss must be issued. Additionally, a statement of the contributions and distributions would also be required.
- Fund expenses: Compensation and all other payments paid from the fund to the private fund adviser (or related persons), as well as all other fees and expenses paid by the fund.
- Portfolio investments: A detailed listing of portfolio investments and the fund’s ownership percentage of each investment. The report must also disclose the compensation paid to the adviser by the portfolio investment during the quarter.
- Prominent disclosures: This is the manner in which expenses, payments, allocations, rebates, waivers, and offsets are calculated. These calculations must be cross-referenced to the organizational and offering documents.
- Issuance of fairness opinion: The SEC expressed that there is a conflict of interest when the adviser offers existing fund investors the option to sell or exchange their interests in the private fund for interests in another vehicle advised by the adviser (an adviser-led secondary transaction). The proposed rule would prohibit an adviser from completing an adviser-led secondary transaction unless the adviser distributes to the effected investors a fairness opinion from an independent opinion provider prior to the closing of the transaction. The adviser must also distribute a summary of material business relationships the adviser has (or has had within the past two years) with the independent opinion provider.
- Compliance program review: This would require all registered advisers (including those that do not manage private funds) to complete (and document in written format) a formal review of their compliance program.
Imposed Prohibitions on Private Fund Advisers
In addition to the increased reporting above, the proposed reform would also impose important prohibitions on all private fund advisers (including unregistered advisers), such as:
- Borrowing money from the fund.
- Charging fees related to a portfolio investment on a non-pro rata basis when multiple clients and the adviser have invested in the same portfolio investment.
- Charging the fund or portfolio investment fees for services the adviser does not provide.
- Limiting the adviser liability for breach of fiduciary trust.
- Passing fees incurred by the adviser for the examination by the government or other regulating body to the fund.
- Preferential treatment (related to investor redemptions, transparency about portfolio holdings, and fees) to certain investors that have a negative impact on other investors.
- Reducing adviser clawback by taxes applicable to the adviser.
Congressional Support
On May 15, 2023, eight U.S. Senators issued a letter to the Chair of the SEC encouraging the enactment of the proposal “as soon as practicable.” The Senators cited two notable events such as the collapse of FTX and Silicon Valley Bank. They said, “While the performance reporting provisions in the Private Funds Proposal would not have addressed the widespread fraud at FTX, investors in private funds invested in FTX as its valuation skyrocketed would have had access to detailed, periodic performance results that should have been a starting place to question those values.”
The Senators also noted, “Fund managers often exert significant influence on the companies they invest in. We saw this influence in action when private fund managers called on portfolio company executives to move deposits from Silicon Valley Bank, contributing to the bank’s failure. That episode, in part, demonstrates why the SEC should take clear and affirmative steps to improve governance in the private funds industry.” The SEC is weighing both the comments on the proposed ruling from industry experts, while facing the Congressional pressure to act quickly.
Conclusion
Although these proposed rule changes are not set in stone, the reform does present significant impacts on investments advisers and their private funds. The comments on the ruling were due by November 1, 2022, therefore, we await the results of those comments and the potential finalized reform. In the meantime, our team at Wolf & Company will continue to monitor this ruling and provide further updates when available.
