Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, 16886-16977 [2022-03212]
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Federal Register / Vol. 87, No. 57 / Thursday, March 24, 2022 / Proposed Rules
• Send an email to rule-comments@
sec.gov. Please include File Number S7–
03–22 on the subject line.
SECURITIES AND EXCHANGE
COMMISSION
17 CFR Part 275
[Release Nos. IA–5955; File No. S7–03–22]
RIN 3235–AN07
Private Fund Advisers; Documentation
of Registered Investment Adviser
Compliance Reviews
Securities and Exchange
Commission.
ACTION: Proposed rule.
AGENCY:
The Securities and Exchange
Commission (the ‘‘Commission’’ or the
‘‘SEC’’) is proposing new rules under
the Investment Advisers Act of 1940
(the ‘‘Advisers Act’’ or the ‘‘Act’’). We
propose to require registered investment
advisers to private funds to provide
transparency to their investors regarding
the full cost of investing in private
funds and the performance of such
private funds. We also are proposing
rules that would require a registered
private fund adviser to obtain an annual
financial statement audit of each private
fund it advises and, in connection with
an adviser-led secondary transaction, a
fairness opinion from an independent
opinion provider. In addition, we are
proposing rules that would prohibit all
private fund advisers, including those
that are not registered with the
Commission, from engaging in certain
sales practices, conflicts of interest, and
compensation schemes that are contrary
to the public interest and the protection
of investors. All private fund advisers
would also be prohibited from
providing preferential treatment to
certain investors in a private fund,
unless the adviser discloses such
treatment to other current and
prospective investors. We are proposing
corresponding amendments to the
Advisers Act books and records rule to
facilitate compliance with these
proposed new rules and assist our
examination staff. Finally, we are
proposing amendments to the Advisers
Act compliance rule, which would
affect all registered investment advisers,
to better enable our staff to conduct
examinations.
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SUMMARY:
Comments should be received on
or before April 25, 2022.
ADDRESSES: Comments may be
submitted by any of the following
methods:
DATES:
Electronic Comments
• Use the Commission’s internet
comment form (https://www.sec.gov/
rules/submitcomments.htm); or
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Paper Comments
• Send paper comments to Vanessa
A. Countryman, Secretary, Securities
and Exchange Commission, 100 F Street
NE, Washington, DC 20549–1090.
All submissions should refer to File
Number S7–03–22. This file number
should be included on the subject line
if email is used. To help us process and
review your comments more efficiently,
please use only one method. The
Commission will post all comments on
the Commission’s website (https://
www.sec.gov/rules/proposed.shtml).
Comments are also available for website
viewing and printing in the
Commission’s Public Reference Room,
100 F Street NE, Washington, DC 20549,
on official business days between the
hours of 10:00 a.m. and 3:00 p.m.
Operating conditions may limit access
to the Commission’s public reference
room. All comments received will be
posted without change; we do not edit
personal identifying information from
submissions. You should submit only
information that you wish to make
available publicly.
Studies, memoranda, or other
substantive items may be added by the
Commission or staff to the comment file
during this rulemaking. A notification of
the inclusion in the comment file of any
such materials will be made available
on the Commission’s website. To ensure
direct electronic receipt of such
notifications, sign up through the ‘‘Stay
Connected’’ option at www.sec.gov to
receive notifications by email.
FOR FURTHER INFORMATION CONTACT:
Christine Schleppegrell, Senior Counsel;
Thomas Strumpf, Senior Counsel;
Melissa Roverts Harke, Senior Special
Counsel; Michael C. Neus, Private
Funds Attorney Fellow; or Melissa S.
Gainor, Assistant Director, Investment
Adviser Rulemaking Office, or Marc
Mehrespand, Branch Chief, Chief
Counsel’s Office, at (202) 551–6787 or
IArules@sec.gov, Division of Investment
Management, Securities and Exchange
Commission, 100 F Street NE,
Washington, DC 20549–8549.
SUPPLEMENTARY INFORMATION: The
Securities and Exchange Commission
(the ‘‘Commission’’) is proposing for
public comment 17 CFR 275.206(4)–10
(new rule 206(4)–10), 17 CFR
275.211(h)(1)–1 (new rule 211(h)(1)–1),
17 CFR 275.211(h)(1)–2 (new rule
211(h)(1)–2), 17 CFR 275.211(h)(2)–1
(new rule 211(h)(2)–1), 17 CFR
275.211(h)(2)–2 (new rule 211(h)(2)–2),
and 17 CFR 275.211(h)(2)–3 (new rule
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211(h)(2)–3) under the Investment
Advisers Act of 1940 [15 U.S.C. 80b–1
et seq.] (the ‘‘Advisers Act’’); 1 and
amendments to 17 CFR 275.204–2 (rule
204–2) and 17 CFR 275.206(4)–7 (rule
206(4)–7) under the Advisers Act.
Table of Contents
I. Background and Need for Reform
II. Discussion of Proposed Rules for Private
Fund Advisers
A. Quarterly Statements
1. Fee and Expense Disclosure
2. Performance Disclosure
3. Preparation and Distribution of
Quarterly Statements
4. Consolidated Reporting for Certain Fund
Structures
5. Format and Content Requirements
6. Recordkeeping for Quarterly Statements
B. Mandatory Private Fund Adviser Audits
1. Requirements for Accountants
Performing Private Fund Audits
2. Auditing Standards for Financial
Statements
3. Preparation of Audited Financial
Statements
4. Prompt Distribution of Audited
Financial Statements
5. Annual Audit, Liquidation Audit, and
Audit Period Lengths
6. Commission Notification
7. Taking All Reasonable Steps To Cause
an Audit
8. Recordkeeping Provisions Related to the
Proposed Audit Rule
C. Adviser-Led Secondaries
1. Recordkeeping for Adviser-Led
Secondaries
D. Prohibited Activities
1. Fees for Unperformed Services
2. Certain Fees and Expenses
3. Reducing Adviser Clawbacks for Taxes
4. Limiting or Eliminating Liability for
Adviser Misconduct
5. Certain Non-Pro Rata Fee and Expense
Allocations
6. Borrowing
E. Preferential Treatment
1. Recordkeeping for Preferential
Treatment
III. Discussion of Proposed Written
Documentation of All Advisers’ Annual
Reviews of Compliance Programs
IV. Transition Period and Compliance Date
V. Economic Analysis
A. Introduction
B. Economic Baseline
1. Industry Statistics and Affected Parties
2. Sales Practices, Compensation
Arrangements, and Other Business
Practices of Private Fund Advisers
3. Private Fund Adviser Fee, Expense, and
Performance Disclosure Practices
4. Fund Audits and Fairness Opinions
5. Books and Records
6. Documentation of Annual Review Under
the Compliance Rule
1 Unless otherwise noted, when we refer to the
Advisers Act, or any section of the Advisers Act,
we are referring to 15 U.S.C. 80b, at which the
Advisers Act is codified. When we refer to rules
under the Advisers Act, or any section of those
rules, we are referring to title 17, part 275 of the
Code of Federal Regulations [17 CFR part 275], in
which these rules are published.
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C. Benefits and Costs
1. Overview and Broad Economic
Considerations
2. Quarterly Statements
3. Prohibited Activities and Disclosure of
Preferential Treatment
4. Audits, Fairness Opinions, and
Documentation of Annual Review of
Compliance Programs
5. Recordkeeping
D. Effects on Efficiency, Competition, and
Capital Formation
1. Efficiency
2. Competition
3. Capital Formation
E. Alternatives Considered
1. Alternatives to the Requirement for
Private Fund Advisers To Obtain an
Annual Audit
2. Alternatives to the Requirement To
Distribute a Quarterly Statement to
Investors Disclosing Certain Information
Regarding Costs and Performance
3. Alternative to the Required Manner of
Preparing and Distributing Quarterly
Statements and Audited Financial
Statements
4. Alternatives to the Prohibitions From
Engaging in Certain Sales Practices,
Conflicts of Interest, and Compensation
Schemes
5. Alternatives to the Requirement That an
Adviser To Obtain a Fairness Opinion in
Connection With Certain Adviser-Led
Secondary Transactions
6. Alternatives to the Prohibition From
Providing Certain Preferential Terms and
Requirement To Disclose All Preferential
Treatment
F. Request for Comment
VI. Paperwork Reduction Act
A. Introduction
B. Quarterly Statements
C. Mandatory Private Fund Adviser Audits
D. Adviser-Led Secondaries
E. Disclosure of Preferential Treatment
F. Written Documentation of Adviser’s
Annual Review of Compliance Program
G. Recordkeeping
H. Request for Comment
VII. Initial Regulatory Flexibility Analysis
A. Reasons for and Objectives of the
Proposed Action
1. Proposed Rule 211(h)(1)–1
2. Proposed Rule 211(h)(1)–2
3. Proposed Rule 206(4)–10
4. Proposed Rule 211(h)(2)–1
5. Proposed Rule 211(h)(2)–2
6. Proposed Rule 211(h)(2)–3
7. Proposed Amendments to Rule 204–2
8. Proposed Amendments to Rule 206(4)–
(7)
B. Legal Basis
C. Small Entities Subject to Rules
D. Projected Reporting, Recordkeeping, and
Other Compliance Requirements
1. Proposed Rule 211(h)(1)–1
2. Proposed Rule 211(h)(1)–2
3. Proposed Rule 206(4)–10
4. Proposed Rule 211(h)(2)–1
5. Proposed Rule 211(h)(2)–2
6. Proposed Rule 211(h)(2)–3
7. Proposed Amendments to Rule 204–2
8. Proposed Amendments to Rule 206(4)–
(7)
E. Duplicative, Overlapping, or Conflicting
Federal Rules
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F. Significant Alternatives
G. Solicitation of Comments
VIII. Consideration of Impact on the
Economy
IX. Statutory Authority
I. Background and Need for Reform
In the wake of the 2007–2008
financial crisis, Congress passed and the
President signed the Dodd-Frank Wall
Street Reform and Consumer Protection
Act of 2010 (‘‘Dodd-Frank Act’’), which
increased the Commission’s oversight
responsibility for private fund advisers.2
Among other things, the Dodd-Frank
Act amended the Advisers Act generally
to require advisers to private funds to
register with the Commission and to
require the Commission to establish
reporting and recordkeeping
requirements for advisers to private
funds for investor protection and
systemic risk purposes.3 The DoddFrank Act also added section 211(h) to
the Advisers Act, which, among other
things, directs the Commission to
‘‘facilitate the provision of simple and
clear disclosures to investors regarding
the terms of their relationships with
. . . investment advisers’’ and
‘‘promulgate rules prohibiting or
restricting certain sales practices,
conflicts of interest, and compensation
schemes for investment advisers.’’ 4
Registration and reporting on both
Form ADV and Form PF have been
critical to increasing transparency and
protecting investors in private funds
and assessing systemic risk.5 They also
2 Section 202(a)(29) of the Advisers Act defines
the term ‘‘private fund’’ as an issuer that would be
an investment company, as defined in section 3 of
the Investment Company Act of 1940 (15 U.S.C.
80a–3) (‘‘Investment Company Act’’), but for section
3(c)(1) or 3(c)(7) of that Act. We use ‘‘private fund’’
and ‘‘fund’’ interchangeably throughout this release.
3 See, e.g., Rule Implementing Amendments to the
Investment Advisers Act of 1940, Investment
Advisers Act Release No. 3221 (June 22, 2011)
(‘‘Implementing Release’’); Reporting by Investment
Advisers to Private Funds and Certain Commodity
Pool Operators and Commodity Trading Advisors
on Form PF, Investment Advisers Act Release No.
3308 (Oct. 31, 2011).
4 Dodd-Frank Wall Street Reform and Consumer
Protection Act, section 913(h), Public Law 111–203,
124 Stat. 1376 (2010).
5 The Financial Stability Oversight Council uses
these and other tools to assess private fund impact
on systemic risk. See also U.S. Securities and
Exchange Commission, Division of Investment
Management, Analytics Office, Private Fund
Statistics, available at https://www.sec.gov/
divisions/investment/private-funds-statistics.shtml
(providing a summary of private fund industry
statistics and trends based on data collected
through Form PF and Form ADV). Staff reports,
statistics, and other staff documents (including
those cited herein) represent the views of
Commission staff and are not a rule, regulation, or
statement of the Commission. The Commission has
neither approved nor disapproved the content of
these documents and, like all staff statements, they
have no legal force or effect, do not alter or amend
applicable law, and create no new or additional
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have substantially improved our ability
to understand private fund advisers’
operations and relationships with
investors as private funds play an
increasingly important role in the
financial system and private funds
continue growing in size, complexity,
and number. There are currently 5,037
registered private fund advisers with
over $18 trillion in private fund assets
under management.6 In addition,
private funds and their advisers play an
increasing role in the economy. For
example, hedge funds engage in trillions
of dollars in listed equity and futures
transactions each month.7 Private equity
and other private funds are involved in
mergers and acquisitions, non-bank
lending, and restructurings and
bankruptcies. Venture capital funds
provide funding to start-ups and early
stage companies. Private funds and their
advisers also play an increasingly
important role in the lives of everyday
Americans saving for retirement or
college tuition. Some of the largest
groups of private fund investors include
state and municipal pension plans,
college and university endowments,
non-profit organizations, and high net
worth individuals.8 Numerous investors
also have indirect exposure to private
funds through private pension plans,
endowments, feeder funds established
by banks and other financial
institutions, foundations, and certain
other retirement plans.
During our decade overseeing most
private fund advisers, our staff has
examined private fund advisers to
assess both the issues and risks
presented by their business models and
the firms’ compliance with their
existing legal obligations.9 The
obligations for any person. The Commission has
expressed no view regarding the analysis, findings,
or conclusions contained therein.
6 Form ADV data current as of November 30,
2021.
7 See Division of Investment Management:
Analytics Office, Private Funds Statistics Report:
First Calendar Quarter 2021 (Nov. 1, 2021) (‘‘Form
PF Statistics Report’’), at 31, available at https://
www.sec.gov/divisions/investment/private-fundsstatistics/private-funds-statistics-2021-q1.pdf
(showing aggregate portfolio turnover for hedge
funds managed by large hedge fund advisers (i.e.,
advisers with at least $1.5 billion in hedge fund
assets under management) as reported on Form PF).
8 See Form PF Statistics Report, supra at footnote
7, at 15 (showing beneficial ownership of all funds
by category as reported on Form PF). See also, e.g.,
Public Investors, Private Funds, and State Law,
Baylor Law Review, Professor William Clayton
(June 15, 2020) (‘‘Professor Clayton Article’’), at 354
(noting that public pension plans have dramatically
increased their investment in private funds).
9 See, e.g., OCIE National Examination Program
Risk Alert: Observations from Examinations of
Investment Advisers Managing Private Funds (June
23, 2020) (‘‘EXAMS Private Funds Risk Alert
2020’’), available at https://www.sec.gov/files/
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Commission also has pursued
enforcement actions against private
fund advisers for practices that have
caused private funds to pay more in fees
and expenses than they should have,
which negatively affected returns for
private fund investors, or resulted in
investors not being informed of relevant
conflicts of interest concerning the
private fund adviser and the fund.10
Despite our examination and
enforcement efforts, these activities
persist.11
First, we continue to observe that
private fund investments are often
opaque; advisers frequently do not
provide investors with sufficiently
detailed information about private fund
investments. Without sufficiently clear,
comparable information, even
sophisticated investors would be unable
to protect their interests or make sound
investment decisions. For example,
some investors do not have sufficient
information regarding private fund or
portfolio company fees and expenses to
Private%20Fund%20Risk%20Alert_0.pdf. As of
December 17, 2020, the Office of Compliance,
Inspections and Examinations (‘‘OCIE’’) was
renamed the Division of Examinations (‘‘EXAMS’’).
10 See, e.g., In re Kohlberg Kravis Roberts & Co.
L.P., Investment Advisers Act Release No. 4131
(June 29, 2015) (settled action) (alleging private
fund adviser misallocated more than $17 million in
so-called ‘‘broken deal’’ expenses to its flagship
private equity fund); In re Blackstone Management
Partners L.L.C., et al., Investment Advisers Act
Release No. 4219 (Oct. 7, 2015) (settled action)
(alleging private fund advisers failed to inform
investors about benefits that the advisers obtained
from accelerated monitoring fees and discounts on
legal fees); In re NB Alternatives Advisers LLC,
Investment Advisers Act Release No. 5079 (Dec. 17,
2018) (settled action) (alleging private fund adviser
improperly allocated approximately $2 million of
compensation-related expenses to three private
equity funds it advised).
11 See, e.g., In the Matter of Diastole Wealth
Management, Inc., Investment Advisers Act Release
No. 5855 (Sept. 10, 2021) (settled action) (alleging
private fund adviser failed to disclose to investors
that the adviser periodically made loans to a
company owned by the son of the principal of the
advisory firm and that the private fund’s investment
in the company could be used to repay the loans
made by the adviser); In re Global Infrastructure
Management, LLC, Investment Advisers Act Release
No. 5930 (Dec. 20, 2021) (settled action) (alleging
private fund adviser failed to properly offset
management fees to private equity funds it managed
and made false and misleading statements to
investors and potential investors in those funds
concerning management fee offsets); In the Matter
of EDG Management Company, LLC, Investment
Advisers Act Release No. 5617 (Oct. 22, 2020)
(settled action) (alleging that private equity fund
adviser failed to apply the management fee
calculation method specified in the limited
partnership agreement by failing to account for
write downs of portfolio securities causing the fund
and investors to overpay management fees); In the
Matter of Mitchell J. Friedman, Investment Advisers
Act Release No. 5338 (Sept. 4, 2019) (settled action)
(alleging that the co-owner of a private fund
advisory firm failed to disclose material conflicts of
interest to the private fund it managed and misled
two investors by misrepresenting an investment
opportunity).
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make informed investment decisions,
given those fees and expenses can be
subject to complicated calculation
methodologies (that often include the
application of offsets, waivers, and other
limits); may have varied labels across
private funds; and can affect individual
investors’ returns differently because of
alternative fee arrangements set forth in
side letter agreements. In addition,
advisers often provide private fund
investors with laundry lists of potential
fees and expenses, without giving
details on the magnitude and scope of
fees and expenses charged. Beyond
management fees, performance-based
compensation, and the expenses
charged directly to the funds, some
private fund advisers and their related
persons charge a number of fees and
expenses to the fund’s portfolio
companies. These can include
consulting fees, monitoring fees,
servicing fees, transaction fees,
director’s fees, and others. At the time
of the initial investment and as fund
operations continue, many investors do
not have sufficient information
regarding these fee streams that flow to
the adviser or its related persons and
reduce the return on their investment.
Investors also often lack sufficient
transparency into how private fund
performance is calculated. Advisers
frequently present fund performance
reflecting different assumptions, making
it difficult to measure and compare data
across funds and advisers or compare
the fund’s performance to the investor’s
chosen benchmarks, even where the
assumptions are disclosed. For example,
one adviser may show fund
performance that reflects the use of a
subscription line of credit initially to
fund investments and pay expenses
rather than investor capital. Another
adviser may present only unlevered
performance results that do not reflect
the effect of a subscription line. More
standardized requirements for
performance metrics would allow
private fund investors to make apples to
apples comparisons when assessing the
returns of similar fund strategies over
different market environments and over
time. More standardized requirements
for performance information also would
improve investors’ ability to interpret
complex performance reporting, and
assess the relationship between the fees
paid in connection with an investment
and the return on that investment as
they monitor their investment and
consider potential future investments.
Similarly, investors may not have
information regarding the preferred
terms granted to certain investors (e.g.,
seed investors, strategic investors, those
with large commitments, and
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employees, friends, and family).
Advisers frequently grant preferred
terms to certain investors that often are
not attainable for smaller institutional
investors or individual investors. In
some cases, these terms materially
disadvantage other investors in the
private fund.12
This lack of transparency regarding
costs, performance, and preferential
terms causes an information imbalance
between advisers and private fund
investors, which, in many cases,
prevents private bilateral negotiations
from effectively remedying
shortcomings in the private funds
market. We believe that this imbalance
serves only the adviser’s interest and
leaves many investors without the tools
they need to effectively protect their
interests, whether through negotiations
or otherwise. Moreover, certain advisers
may only provide sufficiently detailed
information following an investor’s
admission to the fund when the primary
bargaining window has closed,
particularly for closed-end funds where
investors have no, or very limited,
options to withdraw.
Enhanced information about costs,
performance, and preferential treatment,
would help an investor better decide
whether to invest or to remain invested
in a particular private fund, how to
invest other assets in the investor’s
portfolio, and whether to invest in
private funds managed by the adviser or
its related persons in the future. More
standardized information would
improve comparability among private
funds with similar characteristics. This
information also would help a private
fund investor better monitor and assess
the true cost of its investments, the
value of the services for which the fund
is paying, and potential conflicts of
interest. For example, enhanced cost
information could allow an investor to
identify when the private fund has
incorrectly, or improperly, assessed a
fee or expense by the adviser contrary
to the adviser’s fiduciary duty,
contractual obligations to the fund, or
12 See, e.g., Securities and Exchange Commission
v. Philip A. Falcone, Harbinger Capital Partners
Offshore Manager, L.L.C. and Harbinger Capital
Partners Special Situations GP, L.L.C., Civil Action
No. 12 Civ. 5027 (PAC) (S.D.N.Y.) and Securities
and Exchange Commission v. and (sic) Harbinger
Capital Partners LLC, Philip A. Falcone and Peter
A. Jenson, Civil Action No. 12 Civ. 5028 (PAC)
(S.D.N.Y.), Civil Action No. 12 Civ. 5027 (PAC)
(S.D.N.Y.), U.S. Securities and Exchange
Commission Litigation Release No. 22831A (Oct. 2,
2013) (‘‘Harbinger Capital’’) (private fund adviser
granted favorable redemption and liquidity terms to
certain large investors in a private fund without
disclosing these arrangements to the fund’s board
of directors and the other fund investors). See also
17 CFR 275.206(4)–8 (rule 206(4)–8 under the
Advisers Act).
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disclosures by the fund or the adviser.
Ultimately, this information would help
investors better understand marketplace
dynamics and potentially improve
efficiency for future investments, for
example, by expediting the process for
reviewing and negotiating fees and
expenses. More competition and
transparency also could lower the costs
of capital for portfolio companies
raising money and increase returns to
investors, potentially bringing greater
efficiencies to this part of the capital
markets.
We also have continued to observe
instances of advisers acting on conflicts
of interest that are not transparent to
investors, provide substantial financial
benefits to the adviser, and potentially
have significant negative impacts on the
private fund’s returns.13 These issues
are widespread in the private fund
context because, in many cases, the
adviser can influence or control the
portfolio company and can extract
compensation without the knowledge of
the fund or its investors. In addition,
private funds typically lack governance
mechanisms that would help check
overreaching by private fund advisers.
For example, although some private
funds may have limited partner
advisory committees (‘‘LPACs’’) or
boards of directors, these types of bodies
may not have the necessary
independence, authority, or
accountability to oversee and consent to
these conflicts or other harmful
practices. Private funds also do not have
comprehensive mechanisms for private
fund investors to exercise effective
governance, which is exacerbated by the
fact that private fund advisers often
provide certain investors with
preferential terms that can create
potential conflicts among the fund’s
investors. Moreover, the interests of one
or more private fund investors may not
represent the interests of, or may
otherwise conflict with the interests of,
other investors in the private fund due
to, among other things, business or
personal relationships or other private
fund investments. To the extent
13 See, e.g., In the Matter of Bluecrest Capital
Management Limited, Investment Advisers Act
Release No. 5642 (Dec. 8, 2020) (settled action)
(alleging that hedge fund adviser strategically reallocated its best performing personnel (traders)
from its flagship hedge fund to its proprietary hedge
fund, which followed an overlapping trading
strategy and that hedge fund adviser failed to
adequately disclose the existence of its proprietary
hedge fund, the movement of traders, and related
conflicts of interest); In the Matter of Monomoy
Capital Management, L.P., Investment Advisers Act
Release No. 5485 (Apr. 22, 2020) (settled order)
(alleging that private fund adviser charged the
fund’s portfolio company for the services of its inhouse operations group without fulling disclosing
this practice).
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investors are afforded governance or
similar rights, such as LPAC
representation, certain fund agreements
permit such investors to exercise their
rights in a manner that places their
interests ahead of the private fund or the
investors as a whole. For example,
certain fund agreements state that,
subject to applicable law, LPAC
members owe no duties to the private
fund or to any of the other investors in
the private fund and are not obligated to
act in the interests of the private fund
or the other investors as a whole.
As an example of advisers acting on
conflicts of interest, certain venture
capital fund advisers use private funds
to obtain a controlling or influential
interest in a non-publicly traded early
stage company and then instruct that
company to hire the adviser or its
related persons to provide certain
services. In these circumstances, the
adviser often sets the terms of the
engagement, including the price paid for
the services. In cases where the adviser
causes the fund to overpay for services
because the services were not negotiated
in an arm’s-length process, the adviser’s
practice of hiring its related persons
harms investors by diminishing the
private fund’s returns. For example, the
adviser sometimes instructs the
company to pay certain of the adviser’s
bills, to reimburse the adviser for
expenses incurred in managing its
investment in the company, or to add to
its payroll adviser employees who
manage the investment. In contrast,
outside of the private fund context, an
adviser often uses private fund clients to
buy shares in a company and may vote
proxies or engage with management and
the board, but absent taking some
extraordinary steps, the adviser’s ability
to influence or control the company is
generally constrained. In addition, if the
company is publicly traded, the
adviser’s attempts to seize control or
make a variety of other changes are
generally visible to its clients and the
public at large.
Although many conflicts of interest
can involve problematic sales practices
or compensation schemes, some can be
managed. For example, advisers have a
conflict of interest with private funds
and investors in those funds when they
value the fund’s assets and use that
valuation as the basis for the calculation
of the adviser’s fees and fund
performance.14 Similarly, advisers or
14 See, e.g., SEC v. Joseph W. Daniel, Litigation
Release No. 19427 (Oct. 13, 2005) and In re Joseph
W. Daniel, Investment Advisers Act Release No.
2450 (Nov. 29, 2005) (settled action) (alleging
adviser failed to properly value holdings of its
hedge fund client, which inflated the management
fees investor paid); In the Matter of Swapnil Rege,
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their related persons have a conflict of
interest with the fund and its investors
when they offer existing fund investors
the option to sell or exchange their
interests in the private fund for interests
in another vehicle advised by the
adviser or any of its related persons (an
‘‘adviser-led secondary transaction’’). In
both of these examples, there are
opportunities for advisers, funds, and
investors to benefit, but there is also a
potential for significant harm if the
adviser’s conflicts are not appropriately
handled, including diminishing the
fund’s returns because of excess fees
and expenses paid to the fund’s adviser
or its related persons. In these cases,
enhanced protections in the form of an
annual private fund audit and a fairness
opinion in connection with an adviserled secondary transaction would help
address the concerns presented by these
conflicts.
Other conflicts of interest are contrary
to the public interest and the protection
of investors, and cannot be managed
given the lack of governance
mechanisms frequent in private funds as
discussed above. For example, we have
observed situations where the adviser
causes one fund to bear more than its
pro rata share of expenses related to a
portfolio investment.15 In these
circumstances, an adviser may unfairly
allocate fees and expenses to benefit
certain favored clients at the expense of
others, indirectly benefiting the adviser.
Through our examinations, our staff also
has encountered instances where
advisers seek to limit their fiduciary
duty or otherwise provide that the
adviser and its related persons will not
be liable to the private fund or investors
for breaching its duties (including
fiduciary duties) or liabilities (that exist
at law or in equity).16 We believe an
adviser that seeks to limit its liability in
such a manner harms the private fund
(and, by extension, the private fund
investors) by putting the adviser’s
interests ahead of the interests of its
private fund client.
Accordingly, based on our experience
overseeing private fund advisers, as well
as private funds’ impact on our financial
Investment Advisers Act Release No. 5303 (July 18,
2019) (settled action) (alleging that an employee of
a private fund adviser mispriced the private fund’s
investments, which resulted in the adviser charging
the fund excess management fees).
15 See, e.g., In the Matter of Lincolnshire
Management, Inc., Investment Advisers Act Release
No. 3927 (Sept. 27, 2014) (settled action) (alleging
private equity adviser to two private funds
misallocated expenses between the funds).
16 See, e.g., EXAMS National Examination
Program Risk Alert: Observations from
Examinations of Private Fund Advisers (Jan. 27,
2022) (‘‘EXAMS Private Funds Risk Alert 2022’’),
available at https://www.sec.gov/files/private-fundrisk-alert-pt-2.pdf.
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system, our economy, and American
investors’ savings, there is a need to
enhance the regulation of private fund
advisers to protect investors, promote
more efficient capital markets, and
encourage capital formation. The
Commission believes that many of the
practices it has observed are contrary to
the public interest and protection of
investors and that these practices, if left
unchecked, would continue to harm
investors.
In addition, given the lack of strong
governance mechanisms at private
funds, their compliance programs take
on added importance in protecting
investors.17 We are proposing an
amendment to the Advisers Act
compliance rule to require all SECregistered advisers, including those that
do not manage private funds, to
document the annual review of their
compliance policies and procedures in
writing.18 Based on staff experience,
some investment advisers do not make
and preserve written documentation of
the annual review of their compliance
policies and procedures, which our
examination staff relies on to help it
understand an adviser’s compliance
program, determine whether the adviser
is complying with the rule, and identify
potential weaknesses in the compliance
program. Advisers can also rely on
written documentation of the annual
review to promote an internal culture of
compliance and accountability. We
believe that requiring written
documentation would focus renewed
attention on the importance of the
annual compliance review process and
would result in records of annual
compliance reviews that would allow
our staff to assess whether an adviser
has complied with the review
requirement of the compliance rule.
II. Discussion of Proposed Rules for
Private Fund Advisers
We are proposing a series of rules
under the Advisers Act that would
specifically address these practices by
advisers to private funds. The goal of
this package of proposed reforms is to
protect those who directly or indirectly
invest in private funds by increasing
visibility into certain practices,
establishing requirements to address
certain practices that have the potential
to lead to investor harm, and prohibiting
adviser activity that we believe is
contrary to the public interest and the
protection of investors. While some of
the investor protection concerns
identified herein may relate to an
adviser’s activities with regard to other
client types (e.g., separately managed
accounts, pooled vehicles that are not
private funds as defined in the Advisers
Act), the proposed reforms are designed
to address concerns that arise out of the
opacity that is prevalent in the private
fund structure. We also are proposing
corresponding amendments to the books
and records requirements in rule 204–2.
We request comment on the following
aspects of the package of proposed
reforms:
• Are there certain activities that this
package of proposed reforms would
address in the private fund context that
we should also address in other contexts
(e.g., separately managed accounts)?
Why or why not?
• Are there certain activities in the
private fund context that this package of
proposed reforms is not addressing but
that we should address?
A. Quarterly Statements
The proposed rule would require an
investment adviser that is registered or
required to be registered with the
Commission to prepare a quarterly
statement that includes certain
information regarding fees, expenses,
and performance for any private fund
that it advises and distribute the
quarterly statement to the private fund’s
investors within 45 days after each
calendar quarter end, unless a quarterly
statement that complies with the
proposed rule is prepared and
distributed by another person.19 We
believe that periodic statements
detailing such information are necessary
to improve the quality of information
provided to fund investors, allowing
them to assess and compare their
private fund investments better. This
information also would improve their
ability to monitor the private fund
adviser to ensure compliance with the
private fund’s governing agreements and
disclosures. While private fund advisers
may currently provide statements to
investors, there is no requirement for
advisers to do so under the Advisers Act
regulatory regime.
We believe advisers should provide
statements to help an investor better
understand the relationship between the
fees and expenses the investor bears and
the performance the investor receives
from the investment because of the
opaque nature of the fees and expenses
typically associated with private fund
investments. For example, a private
fund’s governing documents (e.g.,
limited partnership agreement, limited
liability company agreement, or offering
document) may include broad
characterizations of the types of
17 Id.
18 Proposed
rule 206(4)–7(b).
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potential fees and expenses. In other
cases, the fund’s governing documents
may give the adviser significant
discretion to determine which fees and
expenses relate to, and should be borne
by, the fund. Examples of broad fee and
expense characterizations include ‘‘any
and all fees and expenses related to the
fund’s business or activities,’’ ‘‘any and
all fees and expenses incurred in
connection with the operation of the
fund,’’ and ‘‘any and all fees and
expenses that the adviser shall
determine to be related to the
establishment and operation of the
fund.’’ These provisions do not provide
investors sufficiently detailed
information regarding what fees and
expenses will be charged, how much
those fees and expenses will be, and
how often fees and expenses will be
charged.
We believe that periodic statements
containing certain required information
would allow investors to understand
and monitor their private fund
investments better. For example,
investors could check fees and expenses
paid directly or indirectly by the private
fund against the private fund’s
governing documents. This information
may allow an investor to identify when
the private fund is incorrectly, or
improperly, assessed a fee or expense by
the adviser contrary to the adviser’s
fiduciary duty or the fund’s governing
agreements or disclosures. As discussed
in more detail below, the proposed
quarterly statement also would improve
transparency for investors into both the
myriad ways an adviser and its related
persons benefit from their relationship
with the private fund and the scope of
potential conflicts of interests.
In addition, the proposed quarterly
statement would allow a private fund
investor to compare cost and
performance information across its
private fund investments. This
information would help inform
investment decisions, including
whether to remain invested in certain
private funds or to invest in other
private funds managed by the adviser or
its related persons. More broadly, this
disclosure would help inform investors
about the cost and performance
dynamics of this marketplace and
potentially improve efficiency for future
investments. For example, if an investor
owns interests in funds with similar
investment strategies, the investor may
be in a better position to negotiate lower
fee rates for future investments because
the investor would be aware of the rates
charged by certain advisers in that
segment of the market.
We recognize that many private fund
advisers contractually agree to provide
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Federal Register / Vol. 87, No. 57 / Thursday, March 24, 2022 / Proposed Rules
fee, expense, and performance reporting
to investors. For example, advisers may
provide investors with financial
statements, schedules, or other reports
regarding the fund and its activities.
However, not all private fund investors
are able to obtain this information.
Others may be able to obtain
information, but it may not be
sufficiently clear or detailed reporting
regarding the costs and performance of
a particular private fund. For example,
some advisers report only aggregated
expenses, or do not provide detailed
information about the calculation and
implementation of any negotiated
rebates, credits, or offsets. Without
clear, detailed disclosure, investors are
unable to measure and assess the impact
fees and expenses have on their
investment returns.
Reporting practices also vary across
the private funds industry due to,
among other things, different forms and
templates. Because the proposed
requirement of quarterly statements
would involve a degree of
standardization across the industry, we
believe that investors would be able to
find and compare key information
regarding fees, expenses, and
performance for funds with similar
characteristics more easily than is the
case today. This has the potential to, in
our view, bring greater efficiencies to
the marketplace by improving investor
decision making. For example, investors
likely would be able to compare adviser
compensation across similar funds,
which may assist investors in
determining whether to negotiate or
renegotiate economic terms or whether
to invest or continue to invest in private
funds managed by the adviser.
The proposed quarterly statement
requirement would provide fund-wide
reporting. We believe this approach
would help private fund investors
compare the costs of investing across
private funds. We are not proposing to
require private fund advisers to provide
personalized account statements
showing each individual investor’s fees,
expenses, and performance. The
proposed quarterly statements are
designed, in part, to allow individual
private fund investors to use fund-level
information to perform more personal,
customized calculations. In addition,
these proposed requirements do not
prevent an adviser from providing (or
causing a third party, such as an
administrator, consultant, or other
service provider, to provide), or an
investor from negotiating, personalized
reporting. In the registered fund context,
fund-level reporting has, in our view,
enabled retail investors to understand
their investments better. We believe a
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comparable approach, but one that is
more suitable to the needs of investors
in private funds, is appropriate here.
We request comment on the following
aspects of the proposed rule:
• Should we, as proposed, require
advisers to private funds to prepare a
quarterly statement providing
standardized disclosures regarding the
cost of investing in the private fund and
the private fund’s performance and
distribute the quarterly statement to the
fund’s investors? Should we instead
require advisers to provide investors
with personalized information that takes
into account the investors’ individual
ownership stake in the fund in addition
to, or in lieu of, a statement covering the
private fund? If so, what information
should be included in the personalized
disclosure? For example, should the
statement reflect specific fee
arrangements, including any offsets or
waivers applicable only to the investors
receiving the statement? Do advisers
currently provide personalized fee,
expense, and performance disclosures?
If so, what other types of information do
advisers or funds typically include? Do
they automate such disclosures? How
expensive and complex would it be for
advisers to create and deliver
personalized disclosures? How useful
would it be for investors to receive
personalized disclosures?
• Would investors find data regarding
the private fund’s fees, expenses, and
performance useful given that certain
investors may have different economic
arrangements with the adviser, such as
fee breaks or expense caps? Should we
require advisers to disclose in the
quarterly statement whether investors
are subject to different economic
arrangements, whether documented in
side letters or other written agreements
or, to the extent applicable, as a result
of different class terms? If so, should we
require advisers to list the rates or
otherwise show a range?
• Should the quarterly statement rule
apply to registered advisers to private
funds as proposed or should it apply to
all advisers to private funds? Should it
apply to exempt reporting advisers?
Should the rule include any exceptions
for categories of advisers? If so, what
conditions should apply to such an
exception?
• Should the rule require advisers to
prepare and distribute the quarterly
statements only to private fund
investors, as proposed? Alternatively,
should the rule require advisers to
provide quarterly statements to
investors in other types of pooled
investment vehicles, such as a vehicle
that relies on an exclusion from the
definition of ‘‘investment company’’ in
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section 3 of the Investment Company
Act other than section 3(c)(1) or 3(c)(7)
of that Act? For example, should we
require advisers to provide quarterly
statements to investors in pooled
investment vehicles that rely on the
exclusion from the definition of
‘‘investment company’’ in section
3(c)(5)(C) of that Act? 20
• The proposed rule would require an
adviser to distribute the quarterly
statement to the private fund’s investors
within 45 days after each calendar
quarter end, unless such a quarterly
statement is prepared and distributed by
another person. Would this provision
eliminate burdens where there are
multiple advisers to the same fund,
while still providing the fund’s
investors with the benefits of the
quarterly statement? Would the fund’s
primary adviser typically prepare and
distribute the quarterly statement in
these circumstances? How would
advisers that do not prepare and
distribute a quarterly statement in
reliance on another adviser demonstrate
compliance with this requirement?
• The proposed rule would require
advisers to prepare and distribute a
quarterly statement disclosing certain
information regarding a private fund’s
fees, expenses, and performance. Are
there alternative approaches we should
require to improve investor protection
and bring greater efficiencies to the
market? For example, should we
establish maximum fees that advisers
may charge at the fund level? Should we
prohibit certain compensation
arrangements, such as the ‘‘2 and 20’’
model? Should we prohibit advisers
from receiving compensation from
portfolio investments to the extent they
also receive management fees from the
fund? Should we require advisers to
disclose their anticipated management
fee revenue and operating budget to
private fund investors or an LPAC or
other similar body (despite the
limitations of private fund governance
mechanisms, as discussed above) on an
annual or more frequent basis? Should
we impose limitations on management
fees (which are typically paid regardless
of whether the fund generates a profit),
but not impose limitations on
performance-based compensation
(which is typically tied to the success of
the fund)? Should we prohibit
20 Section 3(c)(5)(C) of the Investment Company
Act provides an exclusion from the definition of
investment company for any person who is not
engaged in the business of issuing redeemable
securities, face-amount certificates of the
installment type or periodic payment plan
certificates, and who is primarily engaged in the
business of purchasing or otherwise acquiring
mortgages and other liens on and interests in real
estate.
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management fees from being charged as
a percentage of committed capital and
instead only permit management fees to
be based on invested capital, net asset
value, and other similar types of fee
bases? Should we prohibit certain
expense practices or arrangements, such
as expense caps provided to certain, but
not all, investors?
• Similarly, should we prohibit
certain types of private fund
performance information in the
quarterly statement? For example,
should we prohibit advisers from
presenting performance with the impact
of fund-level subscription facilities?
Should we prohibit advisers from
presenting combined performance for
multiple funds, such as a main fund and
a co-investment fund that pays lower or
no fees?
• Do private fund advisers or their
related persons receive other economic
benefits that the rule should require
advisers to disclose in the quarterly
statement? For example, should the
quarterly statement also require
disclosure and quantification of the
kinds of economic benefits commonly
received by advisers or their related
persons from broker-dealers or other
service providers to private funds, such
as hedge funds? Why or why not?
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1. Fee and Expense Disclosure
The proposed rule would require an
investment adviser that is registered or
required to be registered to prepare and
distribute quarterly statements with
certain information regarding fees and
expenses, including fees and expenses
paid by underlying portfolio
investments to the adviser or its related
persons. While the types of fees and
expenses charged to private funds can
vary across the industry, private funds
are often more expensive than other
asset classes because the scope and
magnitude of fees and expenses paid
directly and indirectly by private fund
investors can be extensive. Investors
typically compensate the adviser for
managing the affairs of the fund, often
in the form of management fees.21 On
top of that, investors typically pay or
otherwise bear performance-based
compensation.22 A fund’s portfolio
21 Certain private fund advisers utilize a passthrough expense model where the private fund pays
for most, if not all, expenses, including the adviser’s
expenses, but the adviser does not charge a
management fee. See infra section II.D.2. for a
discussion of such pass-through expense models.
22 Investors typically enter into agreements under
which the private fund pays such compensation
directly to the adviser or its affiliates. Investors
generally bear such compensation indirectly
through their investment in the private fund;
however, certain agreements may require investors
to pay the adviser directly.
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investments also may pay fees to the
adviser or its related persons. For
example, principals of the adviser may
receive cash or non-cash
compensation—such as equity awards
or stock options—for serving as
directors of a portfolio investment
owned by the private fund. Portfolio
investment compensation is typically in
addition to compensation paid or
allocated to the adviser or its related
persons at the fund level, unless the
fund’s governing documents require the
adviser to offset portfolio investment
compensation against other revenue
streams or otherwise provide a rebate to
investors. Compensation at the
‘‘portfolio investment-level’’ is more
common for certain private funds—such
as private equity funds or real estate
funds—and less common for others—
such as hedge funds.
Investors generally are required to
bear all expenses related to the
operation of the fund and its portfolio
investments. In addition to expenses
such as organizational and offering
expenses, private fund investors also
frequently bear expenses that vary based
on the private fund’s strategy and
contractual agreements. For example,
hedge fund investors indirectly bear
trading expenses. Investors in private
equity and venture capital funds
indirectly bear expenses associated with
fund investments, such as deal sourcing
and due diligence expenses, including
for investments that are
unconsummated. Investors in private
funds with a real estate investment
strategy also indirectly bear expenses
related to property management,
environmental reviews, and site
inspections. These expenses generally
are uncapped, and, unlike a fund’s
performance-based compensation,
private fund investors are typically
required to bear them regardless of
whether the fund or the applicable
investment generates a positive return
for investors.
Investors often lack transparency
regarding the total cost of such fees and
expenses.23 For example, even though
investors indirectly bear the costs
23 See Hedge Fund Transparency: Cutting
Through the Black Box, The Hedge Fund Journal,
James R. Hedges IV (Oct. 2006) (stating that ‘‘the
biggest challenges facing today’s hedge fund
industry may well be the issues of transparency and
disclosure’’), available at https://thehedgefund
journal.com/hedge-fund-transparency/; Fees &
Expenses, Private Funds CFO (Nov. 2020) at 12
(noting that it is becoming increasingly complicated
for investors to determine what the management fee
covers versus what is a partnership expense and
stating that the ‘‘formulas for management fees are
complex and unique to different investors.’’),
available at https://www.troutman.com/images/
content/2/6/269858/PFCFO-FeesExpenses-Nov20Final.pdf.
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associated with a portfolio investment
paying fees to the adviser or its related
persons, advisers often do not disclose
the magnitude or scope of these fees to
investors. Opaque reporting practices
make it difficult for investors to measure
and evaluate performance accurately
and to make informed investment
decisions.24 Moreover, such reporting
practices may prevent private fund
investors from assessing whether the
type and amount of fees and expenses
borne by the private fund comply with
the fund’s governing agreements and
can lead to problematic compensation
schemes and sales practices with
investors bearing excess or improper
fees and expenses. The Commission has
brought enforcement actions related to
the disclosure and allocation of fees and
expenses by private fund advisers. For
example, we have alleged in settled
enforcement actions that advisers have
received undisclosed fees,25 improperly
shifted expenses away from the
adviser,26 and misallocated fees and
expenses among private fund clients.27
Staff has observed similarly problematic
compensation schemes and sales
practices in its examinations of private
fund advisers.28 For example, staff has
observed advisers that charge private
funds for expenses not permitted under
the fund documents. Staff has also
observed advisers improperly allocate
shared expenses, such as broken-deal,
due diligence, and consultant expenses,
among private fund clients and their
own accounts.
We have seen a significant increase in
investors seeking transparency
regarding fees and expenses. For
example, certain investors and industry
groups have encouraged advisers to
adopt uniform reporting templates to
promote transparency and alignment of
interests between advisers and
24 See, e.g., Letter from State Treasurers and
Comptrollers to Mary Jo White, U.S. Securities &
Exchange Commission (July 21, 2015), available at
https://comptroller.nyc.gov/wp-content/uploads/
documents/SEC_SignOnPDF.pdf; see also Letter
from Americans for Financial Reform Education
Fund to Chairman Gary Gensler, U.S. Securities &
Exch. Commission (July 6, 2021), available at
https://ourfinancialsecurity.org/wp-content/
uploads/2021/07/Letter-to-SEC-re_-Private-Equity7.6.21.pdf .
25 See, e.g., In the Matter of Blackstone
Management Partners, L.L.C., et. al., Investment
Advisers Act Release No. 4219 (Oct. 7, 2015)
(settled action).
26 See, e.g., In the Matter of Cherokee Investment
Partners, LLC and Cherokee Advisers, LLC,
Investment Advisers Act Release No. 4258 (Nov. 5,
2015) (settled action).
27 See, e.g., In the Matter of Lincolnshire
Management, Inc., Investment Advisers Act Release
No. 3927 (Sept. 22, 2014) (settled action).
28 See EXAMS Private Funds Risk Alert 2020,
supra footnote 9.
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investors.29 Despite these efforts, many
advisers still do not voluntarily provide
adequate disclosure to investors. The
proposed quarterly statement rule
would mandate them to provide it.
a. Private Fund-Level Disclosure
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The proposed quarterly statement rule
would require private fund advisers to
disclose the following information to
investors in a table format:
(1) A detailed accounting of all
compensation, fees, and other amounts
allocated or paid to the adviser or any
of its related persons by the private fund
during the reporting period (‘‘adviser
compensation’’);
(2) A detailed accounting of all fees
and expenses paid by the private fund
during the reporting period other than
those listed in paragraph (1) above
(‘‘fund expenses’’); and
(3) The amount of any offsets or
rebates carried forward during the
reporting period to subsequent quarterly
periods to reduce future payments or
allocations to the adviser or its related
persons.30
The table would provide investors
with comprehensive fee and expense
disclosure for the prior quarterly period
(or, in the case of a newly formed
private fund’s initial quarterly
statement, its first two full calendar
quarters of operating results).31 We will
discuss each of these elements in turn.
Adviser Compensation. The proposed
rule would require the fund table to
show a detailed accounting of all
adviser compensation during the
reporting period, with separate line
items for each category of allocation or
payment reflecting the total dollar
amount.32 The proposed rule is
designed to capture all compensation,
fees, and other amounts allocated or
paid to the investment adviser or any of
29 See, e.g., Institutional Limited Partners
Association (‘‘ILPA’’) Reporting Template, available
at https://ilpa.org/reporting-template/(stating that,
since its release, more than one hundred and forty
organizations have endorsed the ILPA reporting
template, including more than twenty advisers).
30 Proposed rule 211(h)(1)–2(b).
31 See proposed rule 211(h)(1)–1 (defining
‘‘reporting period’’ as the private fund’s calendar
quarter covered by the quarterly statement or, for
the initial quarterly statement of a newly formed
private fund, the period covering the private fund’s
first two full calendar quarters of operating results).
To the extent a newly formed private fund begins
generating operating results on a day other than the
first day of a calendar quarter (e.g., January 1), the
adviser should include such partial quarter and the
immediately succeeding calendar quarters in the
newly formed private fund’s initial quarterly
statement. For example, if a fund begins generating
operating results on February 1, the reporting
period for the initial quarterly statement would
cover the period beginning on February 1 and
ending on September 30.
32 Proposed rule 211(h)(1)–2(b)(1).
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its related persons by the fund,
including, but not limited to,
management, advisory, sub-advisory, or
similar fees or payments, and
performance-based compensation.33
We believe requiring advisers to
disclose all forms of adviser
compensation as separate line items
(without prescribing particular
categories of fees) is appropriate because
it would encompass the various forms of
adviser compensation across the private
funds industry. Many private funds
compensate advisers with a ‘‘2 and 20’’
arrangement, consisting of a 2%
management fee and a 20% share of any
profits generated by the fund. Certain
advisers, however, receive other forms
of compensation from private funds in
addition to, or in lieu of, such amounts.
For example, certain advisers charge
private funds administration fees or
servicing fees. The proposal would help
ensure disclosure of the various forms of
adviser compensation, and the
corresponding dollar amounts of each
type of compensation, to current
investors regardless of how an adviser
characterizes the compensation and
regardless of the different economic
arrangements in place. This would
allow investors to understand and
assess the magnitude and scope of
adviser compensation better and help
validate that adviser compensation
conforms to contractual agreements.
In addition to compensation paid to
the adviser, the proposed rule would
require disclosure of compensation,
fees, and other amounts allocated or
paid to the adviser’s ‘‘related persons.’’
We propose to define ‘‘related persons’’
to include: (i) All officers, partners, or
directors (or any person performing
similar functions) of the adviser; (ii) all
persons directly or indirectly
controlling or controlled by the adviser;
(iii) all current employees (other than
employees performing only clerical,
administrative, support or similar
functions) of the adviser; and (iv) any
person under common control with the
adviser.34 The term ‘‘control’’ would be
33 We propose to define ‘‘performance-based
compensation’’ as allocations, payments, or
distributions of capital based on the private fund’s
(or its portfolio investments’) capital gains and/or
capital appreciation. This definition’s scope is
broad and includes cash or non-cash compensation,
including, for example, in-kind allocations,
payments, or distributions of performance-based
compensation. We believe that the broad scope of
the definition, which would capture, without
limitation, carried interest, incentive fees, incentive
allocations, or profit allocations, among other forms
of compensation, is appropriate given the various
forms and types of performance-based
compensation across the private funds industry.
34 Proposed rule 211(h)(1)–1. Form ADV also uses
the same definition. The regulations at 17 CFR
275.206(4)–2 (rule 206(4)–2) use a similar definition
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16893
defined to mean the power, directly or
indirectly, to direct the management or
policies of a person, whether through
ownership of securities, by contract, or
otherwise.35
Many advisers conduct a single
advisory business through multiple
separate legal entities or provide
services to a private fund through
different affiliated entities. The
proposed ‘‘related person’’ definition is
designed to capture the various entities
and personnel an adviser may use to
provide advisory services to, and
receive compensation from, private fund
clients. We considered, but are not
proposing, a broader definition of
related persons to include additional
entities related to the adviser or its
personnel, such as entities the adviser
or its personnel own a financial interest
in but do not control. We are not
proposing a broader definition because
it would likely capture entities or
persons outside of the ones advisers
typically use to conduct a single
advisory business. In addition, the
proposed definition is consistent with
the definition of related person used on
Form ADV, which advisers have
experience assessing as part of their
disclosure obligations on that form. We
believe that the proposed definition
captures the relevant entities without
being overly broad.
Fund Fees and Expenses. The
proposed rule would also require the
fund table to show a detailed accounting
of all fees and expenses paid by the
private fund during the reporting
period, other than those disclosed as
adviser compensation, with separate
line items for each category of fee or
by defining related person to include any person,
directly or indirectly, controlling or controlled by
the adviser, and any person that is under common
control with the adviser.
35 Proposed rule 211(h)(1)–1. The definition, in
addition, provides that (i) each of an investment
adviser’s officers, partners, or directors exercising
executive responsibility (or persons having similar
status or functions) is presumed to control the
investment adviser; (ii) a person is presumed to
control a corporation if the person: (A) Directly or
indirectly has the right to vote 25% or more of a
class of the corporation’s voting securities; or (B)
has the power to sell or direct the sale of 25% or
more of a class of the corporation’s voting
securities; (iii) a person is presumed to control a
partnership if the person has the right to receive
upon dissolution, or has contributed, 25% or more
of the capital of the partnership; (iv) a person is
presumed to control a limited liability company if
the person: (A) Directly or indirectly has the right
to vote 25% or more of a class of the interests of
the limited liability company; (B) has the right to
receive upon dissolution, or has contributed, 25%
or more of the capital of the limited liability
company; or (C) is an elected manager of the limited
liability company; or (v) a person is presumed to
control a trust if the person is a trustee or managing
agent of the trust. Form ADV also uses the same
definition.
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expense reflecting the total dollar
amount.36 Similar to the approach taken
with respect to adviser compensation
discussed above, the proposed rule
would capture all fund fees and
expenses paid during the reporting
period including, but not limited to,
organizational, accounting, legal,
administration, audit, tax, due
diligence, and travel expenses.
We have observed two general trends
in the private funds industry that
support this approach. First, fund
expenses have risen significantly in
recent years for certain private funds
due to, among other things, complex
fund structures, global marketing and
investment efforts, and increased
service provider costs.37 Advisers often
pass on such increases to the private
funds they advise, without providing
investors with detailed disclosure about
the magnitude or type of expenses
actually charged to the fund. Second,
certain advisers have shifted expenses
related to their advisory business to
private fund clients.38 For example,
some advisers charge private fund
clients for salaries and benefits related
to personnel of the adviser. Such
expenses historically have been paid by
advisers with management fee proceeds
or other revenue streams, but are
increasingly being charged as separate
expenses that may not be transparent to
fund investors.39
The proposed quarterly statement rule
would require a detailed accounting of
each category of fund expense. This
would require advisers to list each
specific category of expense as a
separate line item, rather than permit
advisers to group fund expenses into
broad categories. For example, if a fund
paid insurance premiums, administrator
expenses, and audit fees during the
reporting period, a general reference to
‘‘fund expenses’’ on the quarterly
statement would not satisfy the detailed
accounting requirement. Instead, an
adviser would be required to list each
specific category of expense (i.e.,
36 Proposed
rule 211(h)(1)–2(b)(2).
e.g., Coming to Terms: Private Equity
Investors Face Rising Costs, Extra Fees (Dec. 20,
2021), available at https://www.wsj.com/articles/
coming-to-terms-private-equity-investors-facerising-costs-extra-fees-11640001604#:∼:text
=Coming%20to%20Terms%3A%20PrivateEquity%20Investors%20Face%20Rising%20
Costs%2C,and%20some%20expenses
%20are%20excluded%20from%20annual%20fees.;
Key Findings ILPA Industry Intelligence Report
‘‘What is Market in Fund Terms?’’ (2021) (‘‘ILPA
Key Findings Report’’), available at https://ilpa.org/
wp-content/uploads/2021/10/Key-FindingsIndustry-Intelligence-Report-Fund-Terms.pdf.
38 Such practice is often not disclosed, or not
fully disclosed, in private fund documents.
39 See ILPA Key Findings Report, supra footnote
37.
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37 See,
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insurance premiums, administrator
expenses, and audit fees), and the
corresponding dollar amount,
separately. As with adviser
compensation, we believe this approach
would provide private fund investors
with sufficient detail to validate that the
fund expenses borne by the fund
conform to contractual agreements.
To the extent a fund expense also
could be characterized as adviser
compensation under the proposed rule,
the proposed rule would require
advisers to disclose such payment or
allocation as adviser compensation and
not as a fund expense in the quarterly
statement. For example, certain private
funds may engage the adviser or its
related persons to provide services to
the fund, such as consulting, legal, or
back-office services. An adviser would
disclose any compensation, fees, or
other amounts allocated or paid by the
fund for such services as part of the
detailed accounting of adviser
compensation. This approach would
help ensure that investors understand
the entire amount of adviser
compensation allocated or paid to the
adviser and its related persons during
the reporting period.
Offsets, Rebates, and Waivers. We are
proposing to require advisers to disclose
adviser compensation and fund
expenses in the fund table both before
and after the application of any offsets,
rebates, or waivers.40 Specifically, the
proposed rule would require an adviser
to present the dollar amount of each
category of adviser compensation or
fund expense before and after any such
reduction for the reporting period.
Advisers may offset, rebate, or waive
adviser compensation or fund expenses
in a number of circumstances. For
example, a private equity adviser may
enter into a management services
agreement with a fund’s portfolio
company, requiring the company to pay
the adviser a fee for those services. To
the extent the fund’s governing
agreement requires the adviser to share
the fee with the fund investors through
an offset to the management fee, the
management fee would typically be
reduced, on a dollar-for-dollar basis, by
an amount equal to the fee.41 Under the
proposed rule, the adviser would be
required to list the management fee both
before and after the application of the
fee offset.42
40 Proposed
rule 211(h)(1)–2(b).
offset shifts some or all of the economic
benefit of the fee from the adviser to the private
fund investors.
42 Offsets, rebates, and waivers applicable to
certain, but not all, investors through one or more
separate arrangements would be required to be
reflected and described prominently in the fund41 The
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We considered whether to require
advisers to disclose adviser
compensation and fund expenses only
after the application of offsets, rebates,
and waivers, rather than before and
after. We recognize that investors may
find the reduced numbers more
meaningful, given that they generally
reflect the actual amounts borne by the
fund during the reporting period. We
believe, however, that presenting both
figures would provide investors with
greater transparency into advisers’ fee
and expense practices, particularly with
respect to how offsets, rebates, and
waivers affect adviser compensation.
Transparency into fee and expense
practices is important because it would
assist investors in monitoring their
private fund investments and, for
certain investors, would ease their own
efforts at complying with their reporting
obligations.43 We also believe that
advisers would have this information
readily available and both sets of figures
would be helpful to investors in
monitoring whether and how offsets,
rebates, and waivers are applied.
In addition, we are proposing to
require advisers to disclose the amount
of any offsets or rebates carried forward
during the reporting period to
subsequent periods to reduce future
adviser compensation.44 This
information would allow investors to
understand whether they are or the fund
is entitled to additional reductions in
future periods.45 Further, we believe
that this information would assist
investors with their liquidity
management and cash flow models, as
they would have greater insight into the
fund’s projected cash flows and their
obligations to satisfy future capital calls
for adviser compensation with cash on
hand.
We request comment on all aspects of
the proposed content of the fund fee and
expense table, including the following
items:
• Should we require advisers to
disclose all compensation and fund
expenses as proposed? Do commenters
wide numbers presented in the quarterly statement.
See proposed rule 211(h)(1)–2(d) and (g).
43 For example, certain investors, such as U.S.
state pension plans, may be required to report
complete information regarding fees and expenses
paid to the adviser and its related persons.
44 Proposed rule 211(h)(1)–2(b)(3).
45 To the extent advisers are required to offset
fund-level compensation (e.g., management fees) by
portfolio investment compensation (e.g., monitoring
fees), they typically do not reduce adviser
compensation below zero, meaning that, in the
event the monitoring fee offset amount exceeds the
management fee for the applicable period, some
fund documents provide for ‘‘carryforwards’’ of the
unused amount. The carryforwards are used to
offset the management fee in subsequent periods.
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agree with the scope of the proposal?
Why or why not?
• Would the proposed content result
in fund-level fee and expense disclosure
that is meaningful to investors? Are
there other items that advisers should be
required to disclose in the fund table?
Are there any proposed items that we
should eliminate? Would more or less
information about the fees and expenses
charged to the fund be helpful for
investors? Are there any revisions to the
descriptions of fees that would make the
proposed disclosure more useful to
investors?
• Instead of the proposed approach,
should we prescribe a template for the
fund table? Would the increased
comparability of a template be useful to
investors? Would a template be flexible
enough to accommodate changes in the
types of fees and expenses as well as the
types of offsets, rebates, or waivers used
by private fund advisers? Would a
template necessitate repeated updating
as the industry evolves?
• Should we include any additional
definitions of terms or phrases for the
fund table? Should we omit any
definitions we have proposed for the
fund table?
• The proposed rule would require an
adviser to include the compensation
paid to a related person sub-adviser in
its quarterly statement. For private
funds that have sub-advisers that are not
related persons, should we require a
single quarterly statement showing all
adviser compensation (at both the
adviser and sub-adviser levels)? In cases
where a non-related person sub-adviser
does not prepare a quarterly account
statement in reliance on the adviser’s
preparation and distribution of the
quarterly statement to the fund’s
investors, how would advisers reflect
the compensation paid to the subadviser and its related persons? Do
commenters agree that such
compensation would be captured as a
fund expense? Should we require a
separate table covering these fees and
expenses, as well as a separate table
showing portfolio investment
compensation paid to the sub-adviser or
its related person? How would advisers
operationalize this requirement in these
circumstances?
• Should we adopt the proposed
definitions of ‘‘related persons’’ and
‘‘control’’ as proposed? Are they too
broad? Are the proposed definitions
broad enough? Should we add former
personnel of the adviser or its related
persons to the proposed definition? If
so, for how long after a departure from
the adviser or its related persons should
such personnel fall into the definition?
Should the definition of related person
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include family members of adviser
personnel or persons who share the
same household with adviser
personnel? Should the definition
capture any person directly or indirectly
controlled by the adviser’s officers,
partners, or directors (including any
consulting firms controlled by such
persons)? Should it capture operational
partners, senior advisors, or other
similar consultants of the adviser, the
private fund, or its portfolio
investments? Should we add any entity
more than five percent of the ownership
of which is held, directly or indirectly,
by the adviser or its personnel? Should
the definition include any person that
receives, directly or indirectly,
management fees or performance based
compensation from, or in respect of, the
fund; or any person that has an interest
in the investment adviser or general
partner (or similar control person) of the
fund? If we adopt a different definition
of ‘‘related person’’ than what is being
proposed, should we use a different
defined term (such as ‘‘related party’’) to
avoid confusion given that the term
‘‘related person’’ is defined in Form
ADV?
• For purposes of the definition of
‘‘control,’’ are the control presumptions
appropriate in this context? Should we
eliminate or modify any of the
presumptions? For example, should we
eliminate aspects of the definition that
may capture passive investors who do
not have the power to direct the
management or policies of the relevant
entity? Why or why not? Should we add
any additional control presumptions?
For example, should an entity be
presumed to be controlled by an adviser
to the extent the adviser has authority
over the entity’s budget or whether to
hire personnel or terminate their
employment?
• The proposed rule includes a nonexhaustive list of certain types of
adviser compensation and fund
expenses.46 Would this information
assist advisers in complying with the
rule? Should we add any additional
types? If so, which ones and why?
• Do private fund advisers or their
related persons receive other economic
benefits that the rule should require
advisers to disclose in the quarterly
statement? For example, should we
require hedge fund advisers to disclose
46 Proposed rule 211(h)(1)–2(b)(1) includes the
following non-exhaustive list of adviser
compensation: Management, advisory, subadvisory, or similar fees or payments, and
performance-based compensation. Proposed rule
211(h)(1)–2(b)(2) includes the following nonexhaustive list of fund expenses: Organizational,
accounting, legal, administration, audit, tax, due
diligence, and travel fees and expenses.
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16895
the dollar amount of any soft dollar or
similar benefits provided by brokerdealers that execute trades for the funds,
or any benefits provided by hedge fund
prime brokers?
• Do commenters agree with the
scope of the proposed definition of
‘‘performance-based compensation’’?
Should we specify the types of
compensation that should be included
in the definition? For example, should
the definition specify that the term
includes carried interest, incentive fees,
incentive allocations, performance fees,
or profit allocations?
• Should we only require the table to
disclose adviser compensation and fund
expenses after the application of any
offsets, rebates, or waivers, rather than
before and after, as proposed? If so,
why?
• Should we define offsets, rebates,
and waivers? If so, what definitions
should we use and why? Are there any
types of offsets, rebates, and waivers
that we should not require advisers to
reflect in the fund table? If so, which
ones and why? To the extent that
offsets, rebates, or waivers are available
to certain, but not all, investors, are
there any operational concerns with
reflecting and describing those offsets,
rebates, or waivers in the fund-wide
numbers presented in the quarterly
statement? Are there alternatives we
should use?
• Should we require advisers to
disclose the amount of any offsets or
rebates carried forward during the
reporting period to subsequent periods
to reduce future adviser compensation
as proposed? Would this information be
helpful for investors? Do advisers
already provide this information in the
fund’s financial statements or
otherwise?
• Should we require advisers to
provide any additional disclosures
regarding fees and expenses in the
quarterly statement? In particular,
should we require any disclosures from
an investment adviser’s Form ADV Part
2A narrative brochure (if applicable) to
be included in the quarterly statement,
such as more details about an
investment adviser’s fees?
• Should we tailor the disclosure
requirements based on fund type? For
example, should the requirements or
format for hedge funds differ from the
requirements and format for private
equity funds? Are there unique fees or
expenses for types of funds that advisers
should be required to disclose or
otherwise list as a separate line item? If
so, how should we define these types of
funds for these purposes? For example,
should we use the definitions of such
terms used on Form ADV?
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• Do any of the proposed
requirements impose unnecessary costs
or compliance challenges? Please
provide specific data. Are there any
modifications to the proposal that we
could make that would lower those
costs or mitigate those challenges?
Please provide examples.
• The proposed quarterly statement
prescribes minimum fee and expense
information that must be included.
What are the benefits and drawbacks of
prescribing the minimum disclosure to
be included in the quarterly statement
and otherwise permitting advisers to
include additional information? Do
commenters agree that we should allow
advisers to include additional
information? Would the inclusion of
additional information affect whether
investors review the quarterly
statement?
• Certain advisers use management
fee waivers where the amount of
management fees paid by the fund to the
adviser is reduced in exchange for an
increased interest in fund profits.47
Because fund agreements often
document such waivers with complex
and highly technical tax provisions,
should we provide guidance to assist
advisers in complying with the
proposed requirement to describe the
manner in which they are calculated or
specify a methodology for such
calculations?
• Should we permit advisers to
exclude expenses from the quarterly
statement if they are below a certain
threshold? Alternatively, should we
permit advisers to group expenses into
broad categories and disclose them
under single line item—such as
‘‘Miscellaneous Expenses’’ or ‘‘Other
Expenses’’—if the aggregate amount is
de minimis relative to the fund’s size?
Why or why not?
• The proposed rule would require
the initial quarterly statement for newly
formed funds to include start-up and
organizational fees of the fund if they
were paid during the reporting period.
Instead, should the proposed rule
exclude those fees and expenses?
• Should the table provide fee and
expense information for any other
periods? For example, should we
require advisers to disclose all adviser
compensation and fund expenses since
inception (in addition to adviser
compensation and fund expenses
allocated or paid during the applicable
reporting period)? If so, should we
require since-inception information
47 Management fee waiver arrangements often
provide certain economic benefits for the adviser,
such as the possibility of reducing and/or deferring
certain tax obligations.
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only for certain types of funds, such as
closed-end private funds, and not for
other types of funds, such as open-end
private funds?
• We recognize that certain private
fund advisers may already provide
quarterly account or similar statements
to investors, such as advisers that rely
on an exemption from certain disclosure
and recordkeeping requirements
provided by U.S. Commodity Futures
Trading Commission regulations at 17
CFR 4.7. How often are private fund
advisers separately required to provide
such quarterly statements, and how
often do they do so even when not
required? Would there be any overlap
between the proposed quarterly
statement and the existing quarterly
account or similar statements currently
prepared by advisers?
b. Portfolio Investment-Level Disclosure
The proposed quarterly statement rule
would require advisers to disclose the
following information with respect to
any covered portfolio investment,48 in a
single table covering all such covered
portfolio investments:
(1) A detailed accounting of all
portfolio investment compensation
allocated or paid by each covered
portfolio investment during the
reporting period; 49 and
(2) The private fund’s ownership
percentage of each such covered
portfolio investment as of the end of the
reporting period or, if the fund does not
have an ownership interest in the
covered portfolio investment, the
adviser would be required to list zero
percent as the fund’s ownership
percentage along with a brief
description of the fund’s investment in
such covered portfolio investment.50
The proposed rule defines ‘‘portfolio
investment’’ as any entity or issuer in
which the private fund has invested
directly or indirectly.51 This definition
is designed to capture any entity or
issuer in which the private fund holds
an investment including through
holding companies, subsidiaries,
acquisition vehicles, special purpose
vehicles, and other vehicles through
which investments are made or
48 See proposed rule 211(h)(1)–1 (defining
‘‘covered portfolio investment’’ as a portfolio
investment that allocated or paid the investment
adviser or its related persons portfolio investment
compensation during the reporting period).
49 See proposed rule 211(h)(1)–1 (defining
‘‘portfolio investment compensation’’ as any
compensation, fees, and other amounts allocated or
paid to the investment adviser or any of its related
persons by the portfolio investment attributable to
the private fund’s interest in such portfolio
investment).
50 Proposed rule 211(h)(1)–2(c).
51 Proposed rule 211(h)(1)–1.
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otherwise held by the private fund.52 As
a result, the proposed definition may
capture more than one entity or issuer
with respect to any single investment
made by a private fund. For example, if
a private fund invests directly in a
holding company that owns two
subsidiaries, the proposed definition
would capture all three entities.
Depending on a private fund’s
underlying investment structure, an
adviser may have to determine, in good
faith, which entity or entities constitute
the portfolio investment under the
proposed rule.
We considered, but are not proposing,
using the term ‘‘portfolio company,’’
rather than ‘‘portfolio investment.’’ We
believe that the term ‘‘portfolio
company’’ would be too narrow given
that some private funds do not invest in
traditional operating companies. For
example, certain private funds originate
loans and invest in credit-related
instruments, while others invest in more
bespoke assets such as music royalties,
aircraft, and tanker vessels. The
proposed rule would define ‘‘portfolio
investment’’ to apply to all types of
private fund investments and structures.
The proposed definition also is
designed to remain evergreen, capturing
new investment structures as they
continue to evolve.
We recognize, however, that portfolio
investments of certain private funds
may not pay or allocate portfolioinvestment compensation to an adviser
or its related persons. For example,
advisers to hedge funds focusing on
passive investments in public
companies may be less likely to receive
portfolio-investment compensation than
advisers to private equity funds focusing
on control-oriented investments in
private companies. Under the proposed
rule, advisers would only be required to
disclose information regarding covered
portfolio investments, which we
propose to define as portfolio
investments that allocated or paid the
investment adviser or its related persons
portfolio investment compensation
during the reporting period.53 We
52 Certain investment strategies can involve
complex transactions and the use of negotiated
instruments or contracts, such as derivatives, with
counterparties. Although such trading involves a
risk that a counterparty will not settle a transaction
or otherwise fail to perform its obligations under
the instrument or contract and thus result in losses
to the fund, we would generally not consider the
fund to have made an investment in the
counterparty in this context. We believe this
approach is appropriate because any gain or loss
from the investment generally would be tied to the
performance of the derivative and the underlying
reference security, rather than the performance of
the counterparty.
53 See proposed rule 211(h)(1)–1 (defining
‘‘covered portfolio investment’’).
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believe this approach is appropriate
because the portfolio investment table is
designed to highlight the scope and
magnitude of any investment-level
compensation as well as to improve
transparency for investors into the
potential conflicts of interest of the
adviser and its related persons. If an
adviser does not receive such
compensation, we do not believe the
adviser should have such a reporting
obligation. Accordingly, the proposed
rule would not require advisers to list
any information regarding portfolio
investments that do not fall within the
covered portfolio investment definition
for the applicable reporting period.
These advisers, however, would need to
identify portfolio investment payments
and allocations in order to know
whether they must provide the
disclosures under this requirement.
Portfolio Investment Compensation.
The proposed rule would require the
portfolio investment table to show a
detailed accounting of all portfolio
investment compensation allocated or
paid by each covered portfolio
investment during the reporting period,
with separate line items for each
category of allocation of payment
reflecting the total dollar amount,
including (though it is not limited to)
origination, management, consulting,
monitoring, servicing, transaction,
administrative, advisory, closing,
disposition, directors, trustees or similar
fees or payments by the covered
portfolio investment to the investment
adviser or any of its related persons. An
adviser should disclose the identity of
each covered portfolio investment to the
extent necessary for an investor to
understand the nature of the conflicts
associated with such payments.
Similar to the approach taken with
respect to adviser compensation and
fund expenses discussed above, the
proposed rule would require a detailed
accounting of all portfolio investment
compensation paid or allocated to the
adviser and its related persons.54 This
would require advisers to list each
specific type of portfolio investment
compensation, and the corresponding
dollar amount, as a separate line item.
We believe that this approach is
appropriate given that portfolio
investment compensation can take
many different forms and often varies
based on fund type. For example,
portfolio investments of private credit
funds may pay the adviser a servicing
fee for managing a pool of loans held
54 Because
advisers often use separate legal
entities to conduct a single advisory business, the
proposed rule would capture portfolio investment
compensation paid to an adviser’s related persons.
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directly or indirectly by the fund.
Portfolio investments of private real
estate funds may pay the adviser a
property management fee or a mortgageservicing fee for managing the real estate
investments held directly or indirectly
by the fund.
We believe that this disclosure would
inform investors about the scope of
portfolio investment compensation paid
to the adviser and related persons, and
could help provide insight into some of
the conflicts of interest some advisers
face. For example, in cases where the
adviser controls the portfolio
investment, the adviser also generally
has discretion over whether to charge
portfolio investment compensation and,
if so, the rate, timing, method, amount,
and recipient of such compensation.
Additionally, where the private fund’s
governing documents require the
adviser to offset portfolio investment
compensation against other revenue
streams or otherwise provide a rebate to
investors, this information would also
help investors monitor the application
of such offsets or rebates.
The proposed rule would require the
adviser to disclose the amount of
portfolio investment compensation
attributable to the private fund’s interest
in the covered portfolio investment.55
Such amount would not reflect the
portion attributable to any other
person’s interest in the covered portfolio
investment. For example, if the private
fund and another person co-invested in
the same portfolio investment and the
portfolio investment paid the private
fund’s adviser a monitoring fee, the
table would only list the total dollar
amount of the monitoring fee
attributable to the fund’s interest. We
believe this approach is appropriate
because it would reflect the amount
borne by the fund and, by extension, the
investors. This would be meaningful
information for investors because the
amount attributable to the fund’s
interest typically reduces the value of
investors’ indirect interest in the
portfolio investment.56 Subject to the
requirements of the proposed rule,
advisers may, but are not required to,
also list the portion of the fee
55 See proposed rule 211(h)(1)–1 (defining
‘‘portfolio investment compensation’’).
56 We believe that this information would be
meaningful for investors regardless of whether the
private fund has an equity ownership interest or
another kind of interest in the covered portfolio
investment. For example, if a private fund’s interest
in a covered portfolio investment is represented by
a debt instrument, the amount of portfolioinvestment compensation paid or allocated to the
adviser may hinder or prevent the covered portfolio
investment from satisfying its obligations to the
fund under the debt instrument.
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attributable to any other investor’s
interest in the portfolio investment.
Similar to the approach discussed
above with respect to adviser
compensation and fund expenses, an
adviser would be required to list the
amount of portfolio investment
compensation allocated or paid with
respect to each covered portfolio
investment both before and after the
application of any offsets, rebates, or
waivers. This would require an adviser
to present the aggregate dollar amount
attributable to the fund’s interest before
and after any such reduction for the
reporting period. Advisers would be
required to disclose the amount of any
portfolio investment compensation they
initially charge and the amount they
ultimately retain at the expense of the
private fund and its investors. As with
adviser compensation and fund
expenses, we believe this approach
would provide investors with sufficient
detail to validate that portfolio
investment compensation borne by the
fund conforms to contractual
agreements.
Ownership Percentage. The proposed
rule would require the portfolio
investment table to list the fund’s
ownership percentage of each covered
portfolio investment that paid or
allocated portfolio-investment
compensation to the adviser or its
related persons during the reporting
period.57 The adviser would be required
to determine the fund’s ownership
percentage as of the end of the reporting
period. We believe that this information
would provide investors with helpful
context of the amount of portfolio
investment compensation paid or
allocated to the adviser or its related
persons relative to the fund’s
ownership. For example, portfolio
investment compensation may be
calculated based on the portfolio
investment’s total enterprise value or
other similar metric. We believe that the
fund’s ownership percentage would
help private fund investors understand
and assess the magnitude of such
compensation, as well as how it affects
the value of the fund’s investment.
We recognize that calculating the
fund’s ownership percentage may be
difficult in certain circumstances,
especially for funds that do not make
equity investments in operating
companies. For example, a private
equity secondaries fund may own a
preferred security or a hybrid
instrument that entitles the fund to
57 Proposed rule 211(h)(1)–2(c)(2). An adviser
should also list zero percent as the ownership
percentage if the fund has sold or completely
written off its ownership interest in the covered
portfolio investment during the reporting period.
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priority distributions until it receives a
certain return on its initial investment.
A direct lending fund may provide a
loan to a company that entitles the fund
to receive interest payments and a
return of principal. If the fund does not
have an ownership interest in the
covered portfolio investment, such as
when the fund holds a debt instrument,
the adviser would be required to list
zero percent as the fund’s ownership
percentage, along with a brief
description of the fund’s investment in
the portfolio investment table, if the
covered portfolio investment paid or
allocated portfolio-investment
compensation to adviser or its related
persons during the reporting period.
We request comment on all aspects of
the proposed content of the portfolio
investment table, including the
following items:
• Would the proposed rule provide
portfolio investment compensation
disclosure that is meaningful to
investors? Should the rule require
advisers to disclose additional or
different information in the portfolioinvestment table? Would more
information about the fees and expenses
charged to portfolio investments be
helpful for investors?
• Should we include any additional
definitions of terms or phrases for the
portfolio-investment table? Should we
omit any definitions we have proposed
for the portfolio-investment table?
• Is the proposed definition of
‘‘portfolio investment’’ clear? Should we
modify or revise the proposed
definition? For example, should we
define ‘‘portfolio investment’’ as any
person whose securities are beneficially
owned by the private fund or any
person in which the private fund owns
an equity or debt interest? Alternatively,
should we define ‘‘portfolio
investment’’ as any underlying
company, business, platform, issuer, or
other person in which the private fund
has made, directly or indirectly, an
investment? Should we permit advisers
to determine, in good faith, which entity
or entities constitute the portfolio
investment for purposes of the quarterly
statement rule? For example, a fund of
funds may indirectly invest in hundreds
of issuers or entities. Depending on the
underlying structure, control
relationship, and reporting, the fund of
funds’ adviser may have limited
knowledge regarding such underlying
entities or issuers. Should we exclude
such entities or issuers from the
definition of portfolio investment for
such advisers? Is there a different
standard or test we should use? Should
we require such adviser to conduct a
reasonable amount of diligence
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consistent with past practice and/or
industry standards? Why or why not?
• As discussed above, to the extent a
private fund enters into a negotiated
instrument, such as a derivative, with a
counterparty, we would not consider
the private fund to have made an
investment in the counterparty. Do
commenters agree with this approach?
Why or why not? Should we adopt a
different approach for derivatives or
other similar instruments generally? For
purposes of determining whether the
fund has made an investment in an
issuer or entity, should we only include
equity investments? Should we exclude
derivatives? Why or why not? How
should exchange-traded (i.e., not
negotiated) derivatives, including swaps
and options, be treated for purposes of
the rule?
• The proposed definition of portfolio
investment would not distinguish
among different types of private funds.
Is our approach in this respect
appropriate or should we treat certain
funds differently depending on their
strategy or fund type? If so, how should
we reflect that treatment? For example,
should we modify the definition with
respect to a real estate fund to reflect
that such a fund generally invests in real
estate assets, rather than operating
companies? Because a secondaries fund
may indirectly invest in a significant
number of underlying operating
companies or other assets, should we
limit the ‘‘indirect’’ component of the
definition for such funds (or any other
funds that may have indirect exposure
to a significant number of companies or
assets)? Why or why not? Would
additional definitions be appropriate or
useful? Should the proposed rule define
the term ‘‘entity’’ and/or ‘‘issuer’’? If so,
how? Should the proposed rule treat
hedge funds, liquidity funds, and other
open-end private funds differently than
private equity funds and other closedend private funds?
• Should we adopt the approach with
respect to portfolio-investment
compensation as proposed? Do
commenters agree with the scope of the
proposal? Why or why not?
• The proposed rule includes nonexhaustive lists of certain types of fees.
Would this information assist advisers
in complying with the rule? Should we
add any additional types? If so, which
ones and why?
• Should we require advisers to list
each type of portfolio-investment
compensation as a separate line item as
proposed? Would this level of detail be
helpful for investors with respect to
portfolio-investment reporting? Given
that many funds require a management
fee offset of all portfolio-investment
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compensation, is this level of detail
necessary or useful to investors? Should
we instead require advisers to provide
aggregate information for each covered
portfolio investment?
• Should the rule permit advisers to
use project or deal names or other
codes, and if so, what additional
disclosures are necessary for an investor
to understand the nature of the
conflicts?
• We considered only requiring
advisers to disclose the amount of
portfolio investment compensation after
the application of any offsets, rebates, or
waivers, rather than before and after. We
believe the proposed approach would be
more helpful for investors because
investors would have greater insight
into the compensation advisers initially
charge and the amount they ultimately
retain at the expense of the private fund
and its investors. Do commenters agree?
Why or why not?
• Would information about a firm’s
services to portfolio investments be
helpful for investors? Are there any
elements of the proposed requirements
that firms should or should not include?
If so, which ones and why?
• We considered requiring advisers to
disclose the total portfolio-investment
compensation for the reporting period
as an aggregate number, rather than
providing the amount of compensation
allocated or paid by each covered
portfolio investment as proposed.
However, we believe that investmentby-investment information would
provide investors with greater
transparency into advisers’ fee and
expense practices and thus be more
helpful for investors. Do commenters
agree? Should we require advisers to
report a consolidated ‘‘top-line’’ number
that covers all covered portfolio
investments?
• Should we define the term
‘‘ownership interest’’? If so, how should
we define it? For purposes of the rule,
should a private fund be deemed to hold
an ‘‘ownership interest’’ in a covered
portfolio investment only to the extent
the fund has made an equity investment
in the covered portfolio investment?
Why or why not? What types of funds
may not hold an ‘‘ownership interest’’
in a covered portfolio investment?
• The proposed rule would require
advisers to list the fund’s ownership
percentage of each covered portfolio
investment. Because the definition of
‘‘portfolio investment’’ could capture
more than one entity, will advisers be
able to calculate the fund’s ownership
percentage? Are there any changes to
the proposed rule text that could
mitigate this challenge? If a portfolio
investment captures multiple entities,
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should we require advisers to list the
fund’s overall ownership of such
entities? If so, what criteria should
advisers use to determine a fund’s
overall ownership?
• Should we require advisers to
disclose how they allocate or apportion
portfolio-investment compensation
among multiple private funds invested
in the same covered portfolio
investment? If so, how should the
portfolio investment table reflect this
information?
• Certain advisers have discretion or
substantial influence over whether to
cause a fund’s portfolio investment to
compensate the adviser or its related
persons. Should the requirement to
disclose portfolio-investment
compensation apply only to advisers
that have such discretion or authority?
Should such requirement apply if the
adviser is entitled to appoint one or
more directors to the portfolio
investment’s board of directors or
similar governing body (if applicable)?
Is there another standard we should
require?
• We recognize that certain private
funds, such as quantitative and
algorithmic funds and other similar
funds, may have thousands of holdings
and/or transactions during a quarter and
that those funds typically do not receive
portfolio investment compensation.
While the proposed rule would not
require an adviser to include any
portfolio investment that did not pay or
allocate portfolio-investment
compensation to the adviser or its
related persons during the reporting
period in its quarterly statement, these
advisers would need to consider how to
identify such portfolio investment’s
payments and allocations for purposes
of complying with this disclosure
requirement. Should the rule provide
any full or partial exceptions for such
funds? Should we require investmentlevel disclosure for quantitative,
algorithmic, and other similar funds
only where they own above a specified
threshold percentage of the portfolio
investment? For example, should such
funds only be required to provide
investment-level disclosure where they
own 25% or more ownership of any
class of voting shares? Alternatively,
should we use a lower ownership
threshold, such as 20%, 10%, or 5%?
Should we adopt a similar approach for
all private funds, rather than just
quantitative, algorithmic, and other
similar funds? If so, what threshold
should we apply? For instance, should
it be 5%? Or 10%? A higher percentage?
• Should we exclude certain types of
private funds from these disclosures? If
so, which funds and how should we
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define them? For example, should we
exclude private funds that only hold (or
primarily hold) publicly traded
securities, such as hedge funds?
• Should we require layered
disclosure for the portfolio-investment
table (i.e., short summaries of certain
information with references and links to
other disclosures where interested
investors can find more information)?
Would this approach encourage
investors to ask questions and seek more
information about the adviser’s
practices? Are there modifications or
alternatives we should impose to
improve the utility of the information
for private fund investors, such as
requiring the quarterly statement to
present information in a tabular format?
• Are there particular funds that may
require longer quarterly statements than
other funds? Please provide data
regarding the number of funds that have
covered portfolio investments and, with
respect to those funds, the number of
covered portfolio investments per
private fund. Should the Commission
take into account the fact that certain
funds will have more covered portfolio
investments than other funds? For
example, should we require funds that
have more than a specific number of
covered portfolio investments, such as
50 or more covered portfolio
investments, to provide only portfolioinvestment level reporting for a subset
of their covered portfolio investments,
such as a specific number of their
largest holdings during the reporting
period (e.g., their largest ten, fifteen, or
twenty holdings)?
• The proposed rule would require
advisers to list zero percent as the
ownership percentage if the fund has
completely sold or completely written
off its ownership interest in the covered
portfolio investment during the
reporting period. Instead, should we
require or permit advisers to exclude
any such portfolio investments from the
table? Why or why not?
• The proposed rule would require
the adviser to disclose the amount of
portfolio investment compensation
attributable to the private fund’s interest
in the covered portfolio investment that
is paid or allocated to the adviser and
its related persons. Should we require
disclosure of portfolio compensation
paid to other persons (such as coinvestors, joint venture partners, and
other third parties) to the extent such
compensation reduces the value of the
private fund’s interest in the portfolio
investment?
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16899
c. Calculations and Cross References to
Organizational and Offering Documents
The proposed quarterly statement rule
would require each statement to include
prominent disclosure regarding the
manner in which expenses, payments,
allocations, rebates, waivers, and offsets
are calculated.58 This would generally
have the effect of requiring advisers to
describe, for example, the structure of,
and the method used to determine, any
performance-based compensation set
forth in the statement (such as the
distribution waterfall, if applicable) and
the criteria on which each type of
compensation is based (e.g., whether
compensation is fixed, based on
performance over a certain period, or
based on the value of the fund’s assets).
We believe that this disclosure would
assist private fund investors in
understanding and evaluating the
adviser’s calculations.
To facilitate an investor’s ability to
seek additional information, the
quarterly statement also must include
cross references to the relevant sections
of the private fund’s organizational and
offering documents that set forth the
calculation methodology.59 References
to these disclosures would be valuable
so that the investor can compare what
the private fund’s documents state the
fund (and indirectly the investors) will
be obligated to pay to what the fund
(and indirectly the investors) actually
paid during the reporting period and
more easily determine the accuracy of
the charges. For example, including this
information on the quarterly statement
would likely enable an investor to
confirm that the adviser calculated
advisory fees in accordance with the
fund’s organizational and offering
documents and to identify whether the
adviser deducted or charged incorrect or
unauthorized amounts. We believe this
information also would allow the
investor to assess the effect those fees
and costs have had on its investment.
We request comment on the following
aspects of the proposed rule:
• Should we allow flexibility in the
words advisers use, as proposed, or
should we require advisers to include
prescribed wording in disclosing
calculation methodology? If the latter,
what prescribed wording would be
helpful for investors? Does the narrative
style work or are there other
presentation formats that we should
require?
• Should we provide additional
guidance or specify additional
requirements regarding what type of
58 Proposed
rule 211(h)(1)–2(d).
59 Id.
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disclosure generally should or must be
included to describe the manner in
which expenses, payments, allocations,
rebates, waivers, and offsets are
calculated? For example, should we
provide sample disclosures describing
various calculations? Should the rule
require advisers to restate disclosures
from offering memoranda (if applicable)
regarding the manner in which
expenses, payments, allocations,
rebates, waivers, and offsets are
calculated in the quarterly statement?
Do commenters believe that advisers
would prefer to restate offering
memoranda disclosures rather than
drafting new disclosures to avoid
conflicting interpretations of potentially
complex fund terms? Should the rule
only require advisers to provide a cross
reference to the language in the fund’s
governing documents regarding this
information (e.g., identifying the
relevant document and page or section
numbers)?
• Would providing cross references,
as proposed, to the relevant sections of
the private fund’s organizational and
offering documents be helpful for
investors? Would it permit investors to
‘‘cross check’’ or evaluate the adviser’s
calculations? Are there other
alternatives that would achieve our
objectives?
2. Performance Disclosure
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In addition to providing information
regarding fees and expenses, the
proposed rule would require an adviser
to include standardized fund
performance information in each
quarterly statement provided to fund
investors. The proposed rule would
require an adviser to a liquid fund (as
defined below) to show performance
based on net total return on an annual
basis since the fund’s inception, over
prescribed time periods, and on a
quarterly basis for the current year. For
illiquid funds (also defined below), the
proposed rule would require an adviser
to show performance based on the
internal rate of return and a multiple of
invested capital. The proposed rule
would require an adviser to display the
different categories of required
performance information with equal
prominence.60
60 Proposed rule 211(h)(1)–2(e)(2). For example,
the proposed rule would require an adviser to an
illiquid fund to show gross internal rate of return
with the same prominence as net internal rate of
return. Similarly, the proposed rule would require
an adviser to a liquid fund to show the annual net
total return for each calendar year with the same
prominence as the cumulative net total return for
the current calendar year as of the end of the most
recent calendar quarter covered by the quarterly
statement.
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It is essential that quarterly statements
include performance in order to enable
investors to compare private fund
investments and comprehensively
understand their existing investments
and determine what to do holistically
with their overall investment portfolio.
A quarterly statement that includes fee,
expense, and performance information
would allow investors to monitor for
abnormalities and better understand the
impact of fees and expenses on their
investments. For example, a quarterly
statement that includes fee and expense,
but not performance, information would
not allow an investor to perform a costbenefit analysis to determine whether to
retain the current investment or
consider other options or, for an
investor in an illiquid fund, to
determine whether to invest in other
private funds managed by the same
adviser. In addition, current clients or
investors may use fee, expense, and
performance information about their
current investments to inform their
overall investment decisions (e.g.,
whether to diversify) and their view of
the market.
Although there are commonalities
between the performance reporting
elements of the proposed rule and the
performance elements of our recently
adopted marketing rule, the two rules
satisfy somewhat different policy goals.
Our experience has led us to believe
that, while all clients and investors
should be protected against misleading,
deceptive, and confusing information,
as is the policy goal of the marketing
rule,61 the needs of current clients and
investors often differ in some respects
from the needs of prospective clients
and investors, as detailed below.
Current investors should receive
performance reporting that allows them
to evaluate an investment alongside
corresponding fee and expense
information. Current investors also
should receive performance reporting
that is provided at timely, predictable
intervals so that an investor can monitor
and evaluate its investment progress
over time, remain abreast of changes,
compare information from quarter to
quarter, and take action where
possible.62
61 See Investment Adviser Marketing, Investment
Advisers Act Release No. 5653 (Dec. 22, 2021)
(‘‘Marketing Release’’), at section II.A.2.a.iv (noting
that the definition of ‘‘advertisement’’ includes a
communication to a current investor that offers new
or additional advisory services with regard to
securities, provided that the communication
otherwise satisfies the definition of
‘‘advertisement.’’).
62 The marketing rule and its specific protections
would generally not apply in the context of a
quarterly statement. See Marketing Release, supra
footnote 61, at sections II.A.2.a.iv and II.A.4. The
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Currently, there are various
approaches to report private fund
performance to fund investors, often
depending on the type of private fund
(e.g., the fund’s strategy, structure, target
asset class, investment horizon, or
liquidity profile). Certain of these
approaches may be misleading without
the benefit of well-disclosed
assumptions, and others may lead to
investor confusion. For example, an
adviser showing internal rate of return
with the impact of fund-level
subscription facilities could mislead
investors because that method of
calculation would artificially increase
performance metrics.63 An adviser
showing private fund performance as
compared to a public market equivalent
(‘‘PME’’) in a case where the private
fund does not have an appropriate
benchmark could mislead investors to
believe that the private fund
performance will meet or exceed the
performance of the PME. Certain
investors may also mistakenly believe
that their private fund investment has a
liquidity profile that is similar to an
investment in the PME or an index that
is similar to the PME.
Without standardized performance
metrics (and adequate disclosure of the
criteria used and assumptions made in
calculating the performance),64
investors cannot compare their various
private fund investments managed by
the same adviser nor can they gauge the
value of an adviser’s investment
management services by comparing the
performance of private funds advised by
different advisers.65 Standardized
performance information would help an
investor decide whether to continue to
invest in the private fund, if redemption
is possible, as well as more holistically
to make decisions about other
components of the investor’s portfolio.
Furthermore, we believe that proposing
to require advisers to show performance
information alongside fee and expense
information as part of the quarterly
statement would paint a more complete
picture of an investor’s private fund
investment. This would particularly
provide context for investors that are
compliance date for the Marketing Rule is
November 4, 2022.
63 See infra section II.A.2.b. (Performance
Disclosure: Illiquid Funds).
64 Private funds can have various types of
complicated structures and involve complex
financing mechanisms. As a result, an adviser may
need to make certain assumptions when calculating
performance for private funds, specifically illiquid
funds.
65 See David Snow, Private Equity: A Brief
Overview: An introduction to the fundamentals of
an expanding, global industry, PEI Media (2007), at
11 (discussing variations on private equity
performance metrics).
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paying performance-based
compensation and would help investors
understand the true cost of investing in
the private fund. This proposed
performance reporting would also
provide greater transparency into how
private fund performance is calculated,
improving an investor’s ability to
interpret performance results.66
The proposed rule recognizes the
need for different performance metrics
for private funds based on certain fund
characteristics, but also imposes a
general framework to ensure there is
sufficient standardization in order to
provide useful, comparable information
to investors. An adviser would remain
free to include other performance
metrics in the quarterly statement as
long as the quarterly statement presents
the performance metrics prescribed by
the proposed rule and complies with the
other requirements in the proposed rule.
However, advisers that choose to
include additional information should
consider what other rules and
regulations might apply. For example,
although we would not consider
information in the quarterly statement
required by the proposed rule to be an
‘‘advertisement’’ under the marketing
rule, an adviser that offers new or
additional investment advisory services
with regard to securities in the quarterly
statement would need to consider
whether such information would be
subject to the marketing rule.67 An
adviser would also need to consider
whether performance information
presented outside of the required
quarterly statement, even if it contains
some of the same information as the
quarterly statement, would be subject to,
and meet the requirements of, the
marketing rule. Regardless, the quarterly
statement would be subject to the antifraud provisions of the Federal
securities laws.68
66 Private fund investors increasingly request
additional disclosure regarding private fund
performance, including transparency into the
calculation of the performance metrics. See, e.g.,
GPs feel the strain as LPs push for more
transparency on portfolio performance and fee
structures, Intertrust Group (July 6, 2020), available
at https://www.intertrustgroup.com/news/gps-feelthe-strain-as-lps-push-for-more-transparency-onportfolio-performance-and-fee-structures/; ILPA
Principals 3.0, at 36 ‘‘Financial and Performance
Reporting’’ and ‘‘Fund Marketing Materials,’’
available at https://ilpa.org/wp-content/flash/
ILPA%20Principles%203.0/?page=36.
67 See 17 CFR 275.206(4)–1 (rule 206(4)–1). A
communication to a current investor is an
‘‘advertisement’’ when it offers new or additional
investment advisory services with regard to
securities.
68 This would include the anti-fraud provisions of
section 206 of the Advisers Act, rule 206(4)–8 under
the Advisers Act, section 17(a) of the Securities Act,
and section 10(b) of the Exchange Act (and 17 CFR
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Liquid v. Illiquid Fund Determination
The proposed performance disclosure
requirements of the quarterly statement
rule would require an adviser first to
determine whether its private fund
client is an illiquid or liquid fund, as
defined in the proposed rule, no later
than the time the adviser sends the
initial quarterly statement.69 The
adviser would then be required to
present certain performance information
depending on this categorization. The
purpose of these definitions is to
distinguish which of the two particular
performance reporting methods would
apply and is most appropriate, resulting
in a more accurate portrayal of the
fund’s returns over time and allowing
for more standardized comparisons of
the performance of similar funds.
We propose to define an illiquid fund
as a private fund that: (i) Has a limited
life; (ii) does not continuously raise
capital; (iii) is not required to redeem
interests upon an investor’s request; (iv)
has as a predominant operating strategy
the return of the proceeds from
disposition of investments to investors;
(v) has limited opportunities, if any, for
investors to withdraw before
termination of the fund; and (vi) does
not routinely acquire (directly or
indirectly) as part of its investment
strategy market-traded securities and
derivative instruments.70 We believe
these factors are consistent with the
characteristics of illiquid funds and
these factors would align with the
current factors for determining how
certain types of private funds should
report performance under U.S.
Generally Accepted Accounting
Principles (‘‘U.S. GAAP’’).71
Private funds that fall into the
proposed ‘‘illiquid fund’’ definition are
generally closed-end funds that do not
offer periodic redemption options, other
than in exceptional circumstances, such
as in response to regulatory events.
They also do not invest in publicly
traded securities, except for investing a
de minimis amount of liquid assets. We
believe that many private equity, real
estate, and venture capital funds would
fall into the illiquid fund definition, and
therefore, the proposed rule would
require advisers to these types of funds
240.10b–5 (rule 10b–5 thereunder)), to the extent
relevant.
69 Proposed rule 211(h)(1)–2(e)(1). The proposed
rule does not require the adviser to revisit the
determination periodically; however, advisers
should generally consider whether they are
providing accurate information to investors and
whether they need to revisit the liquid/illiquid
determination based on changes in the fund.
70 Proposed rule 211(h)(1)–1 (defining ‘‘illiquid
fund’’).
71 See GAAP ASC 946–205–50–23/24.
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to provide performance metrics that
recognize their unique characteristics,
such as irregular cash flows, which
otherwise make measuring performance
difficult for both advisers and investors
as discussed below.
We propose to define a ‘‘liquid fund’’
as any private fund that is not an
illiquid fund.72 Private funds that fall
into the ‘‘liquid fund’’ definition
generally allow periodic investor
redemptions, such as monthly,
quarterly, or semi-annually. They also
primarily invest in market-traded
securities, except for a de minimis
amount of illiquid assets, and therefore
determine their net asset value on a
regular basis. Most hedge funds would
likely fall into the liquid fund
definition, and therefore, the proposed
rule would require advisers to these
types of funds to provide performance
metrics that show the year-over-year
return using the market value of the
underlying assets. We acknowledge,
however, that there could be
circumstances where an adviser would
determine a hedge fund is an illiquid
fund because it holds less liquid
investments or has limited investors’
ability to redeem some or all of their
interests in the fund. We also recognize
that some private funds may not neatly
fit into the liquid or illiquid
designations. For example, a hybrid
fund is a type of private fund that can
have characteristics of both liquid and
illiquid funds, and whether the fund is
treated as a liquid or illiquid fund under
the rule would depend on the facts and
circumstances.
In any case, the proposed rule would
require advisers to provide performance
reporting for each private fund as part
of the fund’s quarterly statement. The
determination of whether a fund is
liquid or illiquid dictates the type of
performance reporting that must be
included and, because it would result in
funds with similar characteristics
presenting the same type of performance
metrics, we believe this approach would
improve comparability of private fund
performance reporting for fund
investors. As indicated below, we
welcome comment on whether these
definitions lead to meaningful
performance reporting for different
types of private funds in light of the
myriad fund strategies and structures.
We request comment on the following
aspects of the proposed performance
disclosure requirement:
• Should the proposed rule require
advisers to include performance
72 Proposed rule 211(h)(1)–1 (defining ‘‘liquid
fund’’).
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information in investor quarterly
statements? Why or why not?
• Should the proposed rule require
advisers to determine whether a private
fund is a liquid or illiquid fund and
provide performance metrics based on
that determination? Alternatively,
should the rule eliminate the definitions
and give advisers discretion to provide
the proposed performance metrics that
they believe most accurately portray the
fund’s returns?
• Should we define ‘‘illiquid fund’’
and ‘‘liquid fund’’ as proposed or are
there alternative definitions we should
use? Are there other terms we should
use for these purposes? For example,
should we refer to the types of funds
that would provide annual net total
returns under the rule as ‘‘annual return
funds’’ and those that would provide
internal rates of return (IRR) and a
multiple of invested cash (MOIC) under
the rule as ‘‘IRR/MOIC funds’’?
• Are the six factors used in the
definition of ‘‘illiquid fund’’ sufficient
to capture most funds for which an
annual net total return is not an
appropriate measure of performance?
Are there any factors we should add?
For example, should we add a factor
regarding whether the fund produces
irregular cash flows or whether the fund
takes into account unrealized gains
when calculating performance-based
compensation? Should we add as a
factor whether the private fund pays
carried interest? Are there factors we
should eliminate?
• Should we define additional terms
or phrases used within the definition of
‘‘illiquid fund,’’ such as ‘‘has as a
predominant operating strategy the
return of the proceeds from disposition
of investments to investors’’? Would
this characteristic carve out certain
funds, such as real estate funds and
credit funds, for which we generally
believe internal rates of return and a
multiple of invested capital are the
appropriate performance measures? If
so, why? Should we eliminate or modify
this characteristic in the definition of
‘‘illiquid fund’’?
• Should the proposed rule define a
‘‘liquid fund’’ based on certain
characteristics? If so, what
characteristics? For example, should we
define it as a private fund that requires
investors to contribute all, or
substantially all, of their capital at the
time of investment, and invests no more
than a de minimis amount of assets in
illiquid investments? If so, how should
we define ‘‘illiquid investments’’? Are
there other characteristics relating to
redemptions, cash flows, or tax
treatment that we should use to define
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the types of funds that should provide
annual net total return metrics?
• Will advisers be able to determine
whether a private fund it manages is a
liquid or illiquid fund? For example,
how would an adviser classify certain
types of hybrid funds under the
proposed rule? Should the rule include
a third category of funds for hybrid or
other funds? If so, what definition
should we use? Should we amend the
proposed definitions if we adopt a third
category of funds (e.g., should we revise
the definition of ‘‘liquid fund’’ given
that the proposal defines ‘‘liquid fund’’
as any private fund that is not an
illiquid fund)? If a fund falls within the
third category, should the rule require
or permit the private fund to provide
performance metrics that most
accurately portray the fund’s returns?
• Are there scenarios in which an
adviser might initially classify a fund as
illiquid, but the fund later transitions to
a liquid fund (or vice versa)? Should we
provide additional flexibility in these
circumstances? Should the proposed
rule require advisers to revisit
periodically their determination of a
fund’s liquidity status? For example,
should the proposed rule require
advisers to revisit the liquid/illiquid
determination annually, semi-annually,
or quarterly?
• How would an adviser to a private
fund with an illiquid side pocket
classify the private fund under the
proposed rule’s definitions for liquid
and illiquid funds? For example, would
the adviser treat the entire private fund
as illiquid because of the side pocket?
Why or why not? Should we permit or
require the adviser to classify the side
pocket as an illiquid fund, with the
remaining portion of the private fund
classified as a liquid fund?
• Instead of requiring advisers to
show performance with equal
prominence, should the proposed rule
instead allow advisers to feature certain
performance with greater prominence
than other performance as long as all of
the information is included in the
quarterly statement? Why or why not?
a. Liquid Funds
The proposed rule would require
advisers to liquid funds to disclose
performance information in quarterly
statements for the following periods.
First, an adviser to a liquid fund would
be required to disclose the liquid fund’s
annual net total returns for each
calendar year since inception. For
example, a liquid fund that commenced
operations four calendar years ago
would show annual net total returns for
each of the first four years since its
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inception.73 We believe this information
would provide fund investors with a
comprehensive overview of the fund’s
performance over the life of the fund
and improve an investor’s ability to
compare the fund’s performance with
other similar funds. As noted above,
investors can use performance
information in connection with fee and
expense information to analyze the
value of their private fund investments.
The proposed requirement would
prevent advisers from including only
recent performance results or presenting
only results or periods with strong
performance. For similar reasons, it also
would require an adviser to present
these various time periods with equal
prominence.
Second, the adviser would be
required to show the liquid fund’s
average annual net total returns over the
one-, five-, and ten-calendar year
periods.74 However, if the private fund
did not exist for one of these prescribed
time periods, then the adviser would
not be required to provide that
information. Requiring performance
over these time periods would provide
investors with standardized
performance metrics that would reflect
how the private fund performed during
different market or economic
conditions. These time periods would
provide reference points for private
fund investors, particularly when
comparing two or more private fund
investments, and would provide private
fund investors with aggregate
performance information that can serve
as a helpful summary of the fund’s
performance.
Third, the adviser would be required
to show the liquid fund’s cumulative
net total return for the current calendar
year as of the end of the most recent
calendar quarter covered by the
quarterly statement. For example, a
liquid fund that has been in operations
for four calendar years (beginning on
January 1) and seven months would
show the cumulative net total return for
the current calendar year through the
end of the second quarter. We believe
this information would provide fund
investors with insight into the fund’s
most recent performance, which
investors could use to assess the fund’s
performance during current market
73 If a private fund’s inception date were other
than on the first day of a calendar year, the private
fund would show performance for a stub period and
then show calendar year performance. For example,
if the four-year period ended on October 31, 2021,
and the fund’s inception date was August 31, 2017,
the fund would show full calendar year
performance for 2018, 2019, and 2020, and partial
year performance in 2017.
74 Proposed rule 211(h)(1)–2(e)(2)(i)(B).
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conditions. This quarterly performance
information also would provide helpful
context for reviewing and monitoring
the fees and expenses borne by the fund
during the quarter, which the quarterly
statement would disclose.
We believe these performance metrics
would allow investors to assess these
funds’ performance because they
ordinarily invest in market-traded
securities, which are primarily liquid.
As a result, liquid funds generally are
able to determine their net asset value
on a regular basis and compute the yearover-year return using the market-based
value of the underlying assets. We have
taken a similar approach with regard to
registered funds, which also invest a
substantial amount of their assets in
primarily liquid underlying holdings
(e.g., publicly traded securities).75 As a
result, liquid funds, like registered
funds, currently generally report
performance on an annual and quarterly
basis. Investors in a private fund that is
a liquid fund would similarly find this
information helpful. Most traditional
hedge funds would likely fall into the
liquid bucket and would need to
provide disclosures regarding the
underlying assumptions of the
performance (e.g., whether dividends or
other distributions are reinvested).76
We request comment on the following
with respect to the proposed liquid fund
performance requirement:
• Should we require advisers to
provide annual net total returns for
liquid funds, as proposed? Would
showing annual net total returns for
each calendar year since a private fund’s
inception be overly burdensome for
older funds? Would performance
information that is more than 10 years
old be useful to investors? Why or why
not?
• Should the proposed rule define
‘‘annual net total return’’ or specify the
format in which advisers must present
the annual net total returns? Should the
proposed rule specify how advisers
should calculate the annual net total
return, similar to Form N–1A? 77
• The proposed rule would require
advisers to provide performance
information for each calendar year since
inception and over prescribed time
periods (one-, five-, and ten-year
periods). Should the proposed rule
instead only require an adviser to satisfy
75 See Form N–1A. This form requires registered
investment companies to report to investors and file
with the SEC documents containing the fund’s
annual total returns by calendar year and the
highest and lowest returns for a calendar quarter,
among other performance information.
76 See infra section II.A.2.c (Prominent Disclosure
of Performance Calculation Information).
77 See Form N–1A, Item 26(b).
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one of these requirements (i.e., provide
performance each calendar year since
inception or provide performance over
the prescribed time periods)? For funds
that have not been in existence for one
of the prescribed time periods, should
the proposed rule require the adviser to
show the average annual net total return
since inception, instead of the
prescribed time period?
• The proposed rule would require
advisers to provide average annual net
total returns for the private fund over
the one-, five-, and ten-calendar year
periods. However, the proposal would
not prohibit advisers from providing
additional information. Should we
allow advisers to provide performance
information for annual periods other
than calendar years?
• Should the proposed rule define
‘‘average annual net total return’’ or
specify the format in which advisers
must present the average annual net
total returns?
• The proposed rule would require an
adviser to provide ‘‘the cumulative net
total return for the current calendar
year.’’ Instead of using the word
‘‘cumulative’’ net total return, should
the rule use the phrase ‘‘year to date’’
net total return?
• To the extent certain liquid funds
quote yields rather than returns, should
such funds be required or permitted to
quote yields in addition to or instead of
returns?
b. Illiquid Funds
The proposed rule would require
advisers to illiquid funds to disclose the
following performance measures in the
quarterly statement, shown since
inception of the illiquid fund and
computed without the impact of any
fund-level subscription facilities:
(i) Gross internal rate of return and
gross multiple of invested capital for the
illiquid fund;
(ii) Net internal rate of return and net
multiple of invested capital for the
illiquid fund; and
(iii) Gross internal rate of return and
gross multiple of invested capital for the
realized and unrealized portions of the
illiquid fund’s portfolio, with the
realized and unrealized performance
shown separately.
The proposed rule also would require
advisers to provide investors with a
statement of contributions and
distributions for the illiquid fund.78
Since Inception. The proposed rule
would require an adviser to disclose the
illiquid fund’s performance measures
since inception. This proposed
requirement would prevent advisers
78 Proposed
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from including only recent performance
results or presenting only results or
periods with strong performance, which
could mislead investors. We propose to
require this for all illiquid fund
performance measures under the
proposed rule, including the measures
for the realized and unrealized portions
of the illiquid fund’s portfolio.
The proposed rule would require an
adviser to include performance
measures for the illiquid fund through
the end of the quarter covered by the
quarterly statement. We recognize,
however, that certain funds may need
information from portfolio investments
and other third parties to generate
performance data and thus may not
have the necessary information prior to
the distribution of the quarterly
statement. Accordingly, to the extent
quarter-end numbers are not available at
the time of distribution of the quarterly
statement, an adviser would be required
to include performance measures
through the most recent practicable
date, which we generally believe would
be through the end of the quarter
immediately preceding the quarter
covered by the quarterly statement. The
proposed rule would require the
quarterly statement to reference the date
the performance information is current
through (e.g., December 31, 2021).79
Computed Without the Impact of
Fund-Level Subscription Facilities. The
proposed rule would require advisers to
calculate performance measures for each
illiquid fund as if the private fund
called investor capital, rather than
drawing down on fund-level
subscription facilities.80 Such facilities
enable the fund to use loan proceeds—
rather than investor capital—to initially
fund investments and pay expenses.
This practice permits the fund to delay
the calling of capital from investors,
which has the potential to increase
performance metrics artificially.
Many advisers currently provide
performance figures that reflect the
impact of fund-level subscription
facilities. These ‘‘levered’’ performance
figures often do not reflect the fund’s
actual performance and have the
potential to mislead investors.81 For
79 Proposed
rule 211(h)(1)–2(e)(2)(iii).
discussed below, the proposed rule would
also require advisers to prominently disclose the
criteria used, and assumptions made, in calculating
performance. This would include the criteria and
assumptions used to prepare an illiquid fund’s
unlevered performance measures.
81 We recognize that fund-level subscription
facilities can be an important cash management tool
for both advisers and investors. For example, a fund
may use a subscription facility to reduce the overall
number of capital calls and to enhance its ability
to execute deals quickly and efficiently.
80 As
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example, an investor could reasonably
believe that levered performance results
are similar to those that the investor has
achieved from its investment in the
fund. We believe that unlevered
performance figures would provide
investors with more meaningful data
and improve the comparability of
returns.
We propose to define ‘‘fund-level
subscription facilities’’ as any
subscription facilities, subscription line
financing, capital call facilities, capital
commitment facilities, bridge lines, or
other indebtedness incurred by the
private fund that is secured by the
unfunded capital commitments of the
private fund’s investors.82 This
definition is designed to capture the
various types of subscription facilities
prevalent in the market that serve as
temporary replacements or substitutes
for investor capital.83
We would generally interpret the
phrase computed without the impact of
fund-level subscription facilities to
require advisers to exclude fees and
expenses associated with the
subscription facility, such as the interest
expense, when calculating net
performance figures and preparing the
statement of contributions and
distributions. This approach would
cause the net returns for many funds to
be higher than would be the case if such
amounts were included. We believe that
this approach is appropriate, however,
because it is consistent with the policy
goal of this aspect of the proposed rule
(i.e., requiring advisers to show private
fund investors the returns the fund
would have achieved if there were no
subscription facility).84 We request
comment below on whether this
approach is appropriate.
Fund-Level Performance. The
proposed rule would require an adviser
to disclose an illiquid fund’s gross and
82 Proposed rule 211(h)(1)–1. The proposed rule
defines ‘‘unfunded capital commitments’’ as
committed capital that has not yet been contributed
to the private fund by investors, and ‘‘committed
capital’’ as any commitment pursuant to which a
person is obligated to acquire an interest in, or
make capital contributions to, the private fund. See
id.
83 We recognize that a private fund may guarantee
portfolio investment indebtedness. In such a
situation, if the portfolio investment does not have
sufficient cash flow to pay its debt obligations, the
fund may be required to cover the shortfall to
satisfy its guarantee. Even though investors’
unfunded commitments may indirectly support the
fund’s guarantee, the proposed definition would not
cover such fund guarantees. Unlike fund-level
subscription facilities, such guarantees generally are
not put in place to enable the fund to delay the
calling of investor capital.
84 The proposed rule nevertheless would require
advisers to reflect the fees and expenses associated
with the subscription facility in the quarterly
statement’s fee and expense table.
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net internal rate of return and gross and
net multiple of invested capital for the
illiquid fund. The proposed rule also
would require an adviser to provide a
statement of contributions and
distributions for the illiquid fund
reflecting the aggregate cash inflows
from investors and the aggregate cash
outflows from the fund to investors,
along with the fund’s net asset value.
We recognize that illiquid funds have
unique characteristics, such as irregular
cash flows, that make measuring
performance difficult for both advisers
and investors. We also recognize that
internal rate of return and multiple of
invested capital, each as discussed
below, have their drawbacks as
performance metrics.85 We believe,
however, that these metrics, combined
with a statement of contributions and
distributions reflecting cash flows,
would help investors holistically
understand the fund’s performance,
allow investors to diligence the fund’s
performance, and calculate other
performance metrics they may find
helpful. When presented in accordance
with the conditions and other
disclosures required under the proposed
rule, such standardized reporting
measures would provide meaningful
performance information for investors,
allowing them to compare returns
among funds and also to make moreinformed decisions.
We propose to define ‘‘internal rate of
return’’ as the discount rate that causes
the net present value of all cash flows
throughout the life of the private fund
to be equal to zero.86 Cash flows would
be represented by capital contributions
(i.e., cash inflows) and fund
distributions (i.e., cash outflows), and
the unrealized value of the fund would
be represented by a fund distribution
(i.e., a cash outflow). This definition
would provide investors with a timeadjusted return that takes into account
the size and timing of a fund’s cash
flows and its unrealized value at the
time of calculation.87
85 For example, multiple of invested capital does
not factor in the amount of the time it takes for a
fund to generate a return, and internal rate of return
assumes early distributions will be reinvested at the
same rate of return generated at the initial exit.
86 Proposed rule 211(h)(1)–1 (defining ‘‘gross
IRR’’ and ‘‘net IRR’’).
87 When calculating a fund’s internal rate of
return, an adviser would need to take into account
the specific date a cash flow occurred (or is deemed
to occur). Certain electronic spreadsheet programs
have ‘‘XIRR’’ or other similar formulas that require
the user to input the applicable dates. The proposed
requirement that an illiquid fund present its
performance using an internal rate of return aligns
with the U.S. GAAP criteria used to determine
when a private fund must present performance
using an internal rate of return in its audited
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We propose to define ‘‘multiple of
invested capital’’ as (i) the sum of: (A)
The unrealized value of the illiquid
fund; and (B) the value of all
distributions made by the illiquid fund;
(ii) divided by the total capital
contributed to the illiquid fund by its
investors.88 This definition is intended
to provide investors with a measure of
the fund’s aggregate value (i.e., the sum
of clauses (i)(A) and (i)(B)) relative to
the capital invested (i.e., clause (ii)) as
of the end of the applicable reporting
period. Unlike the definition of internal
rate of return, the multiple of invested
capital definition would not take into
account the amount of time it takes for
a fund to generate a return (meaning
that the multiple of invested capital
measure would focus on ‘‘how much’’
rather than ‘‘when’’).
We believe that the proposed
definitions of internal rate of return and
multiple of invested capital are
generally consistent with how the
industry currently calculates such
performance metrics. For example, most
advisers use electronic spreadsheet
programs to calculate a fund’s internal
rate of return. Such programs typically
calculate the internal rate of return as
the interest rate for an investment
consisting of payments (cash outflows)
and income (cash inflows) received over
a period.89 However, we have observed
certain advisers deviate from standard
formulas, or make various assumptions,
when calculating a private fund’s
performance. Accordingly, we believe
that prescribing definitions would
decrease the risk of different advisers
presenting internal rate of return and
multiple of invested capital
performance figures that are not
comparable. Both definitions are
designed to limit any deviations in
calculating the standardized
performance prescribed by the proposed
rule. We believe that this approach is
appropriate because it would provide a
degree of standardization and provide
investors with the relevant information
to compare performance.
An adviser would be required to
present each performance metric on a
gross and net basis.90 Under the
proposed rule, an illiquid fund’s gross
financial statements. See U.S. GAAP ASC 946–205–
50–23/24.
88 Proposed rule 211(h)(1)–1 (defining ‘‘gross
MOIC’’ and ‘‘net MOIC’’).
89 See, e.g., IRR Function, available at https://
support.microsoft.com/en-us/office/irr-function64925eaa-9988-495b-b290-3ad0c163c1bc (noting
that the internal rate of return is closely related to
net present value and that the rate of return
calculated by the internal rate of return is the
interest rate corresponding to a zero net present
value).
90 Proposed rule 211(h)(1)–2(e)(2)(ii).
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performance would not reflect the
deduction of fees, expenses, and
performance-based compensation borne
by the private fund.91 We believe that
presenting both gross and net
performance measures for the illiquid
fund would prevent investors from
being misled. We believe that gross
performance would provide insight into
the profitability of underlying
investments selected by the adviser.
Solely presenting gross performance,
however, may imply that investors have
received the full amount of such
returns. The net performance would
assist investors in understanding the
actual returns received and, when
presented alongside gross performance,
the negative effect fees, expenses, and
performance-based compensation have
had on past performance.
The proposed rule also would require
an adviser to provide a statement of
contributions and distributions for the
illiquid fund. We believe this would
provide private fund investors with
important information regarding the
fund’s performance because it would
reflect the underlying data used by the
adviser to generate the fund’s returns,
which, in many cases, is not currently
provided to private fund investors. Such
data would allow investors to diligence
the various performance measures
presented in the quarterly statement. In
addition, this data would allow the
investors to calculate additional
performance measures based on their
own preferences.
We propose to define statement of
contributions and distributions as a
document that presents:
(i) All capital inflows the private fund
has received from investors and all
capital outflows the private fund has
distributed to investors since the private
fund’s inception, with the value and
date of each inflow and outflow; and
(ii) The net asset value of the private
fund as of the end of the reporting
period covered by the quarterly
statement.92
For similar reasons to those discussed
above, the proposed rule would require
an adviser to prepare the statement of
contributions and distributions without
the impact of any fund-level
subscription facilities. This would
require an adviser to assume the private
fund called investor capital, rather than
drawing down on fund-level
subscription facilities. To avoid double
counting capital inflows, the amount
borrowed under the subscription facility
generally should be reflected as a capital
91 See
proposed rule 211(h)(1)–1 (defining ‘‘gross
IRR,’’ ‘‘net IRR,’’ ‘‘gross MOIC,’’ and ‘‘net MOIC’’).
92 Proposed rule 211(h)(1)–1.
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inflow from investors and an equal
dollar amount of actual capital inflows
from investors generally should not be
reflected on the statement.
Realized and Unrealized
Performance. The proposed rule also
would require an adviser to disclose a
gross internal rate of return and gross
multiple of invested capital for the
realized and unrealized portions of the
illiquid fund’s portfolio, with the
realized and unrealized performance
shown separately.
The value of the unrealized portion of
an illiquid fund’s portfolio typically is
determined by the adviser and, given
the lack of readily available market
values, can be challenging. For example,
an adviser’s valuation policies and
procedures for illiquid investments may
rely on models and unobservable
inputs. This creates a conflict of interest
because the adviser is typically
evaluated and, in certain cases,
compensated based on the fund’s
unrealized performance. Further,
investors often decide whether to invest
in a successor fund based on the
predecessor fund’s performance. These
factors create an incentive for the
adviser to inflate the value of the
unrealized portion of the illiquid fund’s
portfolio. We believe highlighting the
performance of the fund’s unrealized
investments would assist investors in
determining whether the aggregate,
fund-level performance measures
present an overly optimistic view of the
fund’s overall performance. For
example, if the performance of the
unrealized portion of the fund’s
portfolio is significantly higher than the
performance of the realized portion, it
may imply that the adviser’s valuations
are overly optimistic or otherwise do
not reflect the values that can be
realized in a transaction or sale with an
independent third party.
The proposed rule would only require
an adviser to disclose gross performance
measures for the realized and unrealized
portions of the illiquid fund’s portfolio.
We believe that calculating net figures
could involve complex and potentially
subjective assumptions regarding the
allocation of fund-level fees, expenses,
and adviser compensation between the
realized and unrealized portions of the
portfolio.93 In our view, such
assumptions would likely diminish the
benefits net performance measures
would provide.
93 For example, an adviser would have to
determine how to allocate fund organizational
expenses between the realized and unrealized
portions of the portfolio.
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We request comment on the following
with respect to the proposed illiquid
fund performance requirement:
• Are the proposed performance
metrics appropriate? Why or why not?
We recognize that advisers often utilize
different performance metrics for
different funds. Should we add any
other metrics to the proposed rule? For
example, should we require a public
market equivalent or variations of
internal rate of return, such as a
modified internal rate of return that
assumes cash flows are reinvested at
modest rates of return or otherwise
incorporates a cost of capital concept for
funds that do not draw down all, or
substantially all, of investor capital at
the time of investment? If so, should we
prescribe a benchmark for the cost of
capital and reinvestment rates?
• The proposed rule would not
distinguish among different types of
illiquid funds. Is our approach in this
respect appropriate or should we treat
certain illiquid funds differently? If so,
how should we reflect that treatment?
• Are there additional guardrails we
should add to the proposed rule to
achieve the policy goal of providing
investors with comparable performance
information? If so, please explain. Are
there practices that advisers use or
assumptions that advisers make, when
calculating performance that we should
require, curtail, or otherwise require
advisers to disclose?
• Although some investors receive
certain annual performance information
about a private fund if that fund is
audited and distributes financial
statements prepared in accordance with
U.S. GAAP, we believe that the
proposed rule’s performance
information would be helpful for private
fund investors because it would require
performance information to be reported
at more frequent intervals in a
standardized manner. Do commenters
agree? To the extent there are
differences (e.g., the requirement that
performance be computed without the
impact of any fund-level subscription
facilities), would investors find this
confusing? Would disclosure regarding
these differences help to alleviate
investor confusion?
• Would investor confusion or other
concerns arise from requiring
performance information in the
quarterly statement as proposed?
• What, if any, burdens would be
associated with this aspect of the
proposed rule? How can we minimize
any associated burdens while still
achieving our goals?
• Are the proposed definitions
appropriate and clear? If not, how
should we clarify the definitions?
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Should we modify or eliminate any?
Would additional definitions be
appropriate or useful? For example,
should we define any of the terms used
in the definition of internal rate of
return, such as ‘‘net present value’’ or
‘‘discount rate’’? If so, what definitions
should we use?
• Are the definitions of gross IRR,
gross MOIC, net IRR, and net MOIC
appropriate? Should we provide further
guidance or specify requirements in the
proposed rule on how to calculate gross
performance or net performance? If so,
what guidance or requirements? Should
we require advisers to adopt policies
and procedures prescribing specific
methodologies for calculating gross
performance and net performance? Why
or why not? When calculating net
performance, are there additional fees
and expenses that advisers should
include? Alternatively, should we
expressly permit advisers to exclude
certain fees and expenses when
calculating net performance figures,
such as taxes incurred to accommodate
certain, but not all, investor
preferences? Why or why not?
• Similarly, are the definitions of
gross IRR and gross MOIC appropriate
for purposes of calculating the
performance metrics of the realized and
unrealized portions of the illiquid
fund’s portfolio? Should we modify
such definitions to reference specifically
the realized and unrealized portions of
the portfolio, rather than only
referencing the illiquid fund? For
example, should the definition of MOIC
be revised to mean, as of the end of the
applicable calendar quarter: (i) The sum
of (A) the unrealized value of applicable
portion of the illiquid fund’s portfolio,
and (b) the value of all distributions
made by the illiquid fund attributable to
the applicable portion of the illiquid
fund’s portfolio; (ii) divided by the total
capital contributed to the illiquid fund
by its investors attributable to the
applicable portion of the illiquid fund’s
portfolio? Are there other variations we
should impose? Why or why not?
• The Global Investment Performance
Standards (‘‘GIPS’’) are a set of
voluntary standards for calculating and
presenting investment performance. For
purposes of calculating an illiquid
fund’s performance under the proposed
rule, are there any elements found in the
GIPS standards that we should require?
For example, should we require advisers
to disclose composite cumulative
committed capital,94 or should we
94 The GIPS standards define ‘‘committed capital’’
as pledges of capital to an investment vehicle by
investors (limited partners and the general partner)
or the firm. The term ‘‘composite’’ is defined as an
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require advisers to disclose performance
with and without the impact of
subscription facilities? Are there any
definitions we should revise or propose
to be consistent with the definitions
used in the GIPS standards? For
example, the GIPS standards define
‘‘internal rate of return’’ as the return for
a period that reflects the change in value
and the timing and size of external cash
flows and ‘‘multiple of invested capital’’
as the total value divided by since
inception paid-in capital.95 If we were
to adopt such definitions, do
commenters believe that such
definitions would result in different
performance numbers for illiquid funds,
as compared to the performance
numbers that advisers would disclose
under the proposed definitions? Why or
why not? Please provide examples.
• We recognize that advisers and
their related persons typically invest in
private funds on a ‘‘fee-free, carry-free’’
basis (i.e., they are not required to pay
management fees or performance-based
compensation). When calculating a
fund’s performance, how should such
interests be taken into account? Should
we require advisers to exclude such
interests from the calculations,
especially the net performance figures?
• The proposed rule would require
advisers to calculate the various
performance measures without the
impact of any fund-level subscription
facilities. Do commenters agree with
this approach? Should the proposed
rule require advisers to provide the
same performance measures with the
impact of fund-level subscription
facilities? Why or why not? The
proposed rule does not prohibit advisers
from providing the same performance
measures with the impact of fund-level
subscription facilities. Should we
prohibit advisers from doing so?
• Should we define the term
‘‘computed without the impact of any
fund-level subscription facilities’’?
Should we provide additional guidance
or requirements regarding how advisers
generally should or must calculate such
performance measures? If so, what
guidance or requirements should we
provide?
• We recognize that a fund-level
subscription facility has the potential to
aggregation of one or more portfolios that are
managed according to a similar investment
mandate, objective, or strategy. The term
cumulative is not defined in the GIPS standards.
Global Investment Performance Standards (GIPS)
For Firms: Glossary, CFA Institute (2020), available
at https://www.cfainstitute.org/-/media/documents/
code/gips/2020-gips-standards-firms.pdf.
95 Internal rate of return is referred to as moneyweighted return in the GIPS standards, and
multiple of invested capital is referred to as
investment multiple.
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have a greater impact on a fund’s
internal rate of return as compared to its
multiple of invested capital. Should
advisers only be required to provide
‘‘unlevered’’ internal rates of return and
not ‘‘unlevered’’ multiples of invested
capital? If the fund realizes an
investment prior to calling any capital
from investors in respect of such
investment, how would an adviser
calculate a multiple for such
investment?
• The proposed rule would require
advisers to prepare the statement of
contributions and distributions without
the impact of any fund-level
subscription facilities. Would this
information be helpful for investors?
Would advisers be able to prepare such
a statement without making arbitrary
assumptions? Why or why not? For
example, would advisers need to make
assumptions in calculating the preferred
return (if applicable)?
• The proposed rule would require
only gross performance measures for the
realized and unrealized portion of the
illiquid fund’s portfolio. Should the
proposed rule require net performance
information as well? Would net
performance measures be beneficial for
investors despite the drawbacks
discussed above? What assumptions
should we require in calculating net
information? What limitations, if any,
would advisers face in providing net
performance measures?
• Should we define the phrases
‘‘unrealized portion of the illiquid
fund’s portfolio’’ and ‘‘realized portion
of the illiquid fund’s portfolio’’? For
example, should we define the realized
portion to include not only completely
realized investments but also
substantially realized investments to the
extent the fund’s remaining interest is
de minimis? Why or why not?
• Should we require advisers to
disclose the dollar amounts of the
realized and unrealized portions of the
portfolio? Should we also require
advisers to disclose such amounts as
percentages? For example, if the value
of the realized portion of the portfolio
is $250 million and the value of the
unrealized portion is $750 million,
should we require advisers to disclose
those amounts, both as dollar values
and percentages (i.e., 25% ($250
million) of the illiquid fund’s portfolio
is realized, and 75% ($750 million)
remains unrealized)?
• The proposed rule would require
advisers to provide cumulative
performance reporting since inception
of the illiquid fund each quarter. Is this
the right approach? Should the
proposed rule require performance since
inception for each quarter or on an
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annual basis? Should the proposed rule
remove the ‘‘since inception’’
requirement for quarterly reports and
instead require performance for each
quarter of the current year, and
cumulative performance for the current
year? If so, why or why not?
• Should we prescribe specific
periods for illiquid fund performance
reporting? For example, should we
prescribe one-, five-, and/or ten-year
time periods? Instead, should we
require that advisers always present
performance since inception as
proposed? Are there other periods for
which we should require the
presentation of performance results? Are
there any specific compliance issues
that an adviser would face in generating
and presenting performance results for
the required period? For example,
would advisers have the requisite
information to generate or support
performance figures for older funds
from the proposed recordkeeping
requirements and/or performance
presentation requirements? If not,
should we provide an exemption for
advisers that lack such information?
• Liquid funds often have longer
terms than illiquid funds. To the extent
an illiquid fund has been in existence
for an extended period of time, such as
more than ten years, should the rule
prescribe specific periods for
performance reporting for such funds
(e.g., one-, five-, and/or ten-year time
periods)?
• Should we require that advisers
provide performance results current
through the end of the quarter covered
by the quarterly statement as proposed?
In circumstances where quarter-end
numbers are not available at the time of
distribution of the quarterly statement,
should we require an adviser to include
performance measures through the most
recent practicable date as proposed?
Should we define, or provide additional
guidance about, the term ‘‘most recent
practicable date’’? If so, what definition
or additional guidance should we
provide?
• Should the proposed rule require
advisers to make certain, standard
disclosures tailored to each of the
performance metrics mandated in the
proposed rule? For example, should we
require advisers to illiquid funds that
are required to display internal rate of
return to disclose prominently that the
returns do not represent returns on the
investor’s capital commitment and
instead only reflect returns on the
investor’s contributed capital? Should
we require advisers to disclose that an
investor’s actual return on its capital
commitment will depend on how the
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investor invests its uncalled
commitments?
• As noted above, we would generally
interpret the phrase computed without
the impact of fund-level subscription
facilities to require advisers to exclude
fees and expenses associated with the
subscription facility, such as the interest
expense, when calculating net
performance figures and preparing the
statement of contributions and
distributions. Do commenters agree with
this approach? Should we require
advisers to include such amounts
instead? Are there other assumptions
advisers would need to make in
calculating performance information
that the rule should address?
• The proposed rule would require
the statement of contributions and
distributions to reflect the private fund’s
net asset value as of the end of the
applicable quarter. Should we require
advisers to provide additional detail
regarding the unrealized value of the
private fund? For example, should we
require advisers to reflect the portion of
such net asset value that would be
required to be paid to the adviser as
performance-based compensation
assuming a hypothetical liquidation of
the fund?
• The statement of contributions and
distributions generally reflects
aggregate, fund-level numbers. Should
we also require a statement of
contributions and distributions for each
underlying investment? Would a
statement of each investment’s cash
flows be useful to investors? Why or
why not? Would such a requirement be
too burdensome for certain advisers,
especially advisers to private funds that
have a significant number of
investments? Should this requirement
only apply to certain types of funds,
such as private equity, venture capital,
or other similar funds that may invest in
operating companies?
• Should we provide further guidance
or specify requirements on how advisers
generally should or must present
performance? For example, should we
require advisers to present the various
performance metrics with equal
prominence as proposed? Should we
require advisers to present performance
information in a format designed to
facilitate comparison? Should we
provide additional guidance or
requirements regarding how an adviser
should or must calculate the proposed
performance metrics? Is there additional
information that we should require
advisers to disclose when presenting
performance?
• Should we provide further guidance
or specify requirements in the rule on
how advisers generally should or must
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treat taxes for purposes of calculating
performance? For example, should the
rule state that advisers may exclude
taxes paid or withheld with respect to
a particular investor or by a blocker
corporation (but not the illiquid fund as
a whole)?
c. Prominent Disclosure of Performance
Calculation Information
The proposed rule would require
advisers to include prominent
disclosure of the criteria used and
assumptions made in calculating the
performance. Information about the
criteria used and assumptions made
would enable the private fund investor
to understand how the performance was
calculated and help provide useful
context for the presented performance
metrics. Additionally, while the
proposed rule includes detailed
information about the type of
performance an adviser must present for
liquid and illiquid funds, it is still
possible that advisers would make
certain assumptions or rely on specific
criteria that the proposed rule’s
requirements do not address
specifically.
For example, the proposed rule would
require an adviser to display, for a
liquid fund, the annual returns for each
calendar year since the fund’s inception.
If the adviser made any assumptions in
performing that calculation, such as
whether dividends were reinvested, the
adviser should disclose those
assumptions in the quarterly statement.
As another example, for an illiquid
fund, the proposed rule would require
an adviser to display the net internal
rate of return and net multiple of
invested capital. In this case, the adviser
should disclose the assumed fee rates,
including whether the adviser is using
fee rates set forth in the fund
documents, whether it is using a
blended rate or weighted average that
would factor in any discounts, or
whether it is using a different method
for calculating net performance. The
proposed rule requires the disclosure to
be within the quarterly statement.96
Thus, an adviser may not provide the
information only in a separate
document, website hyperlink or QR
code, or other separate disclosure.97 We
believe that this information is integral
to the quarterly statement because it
would enable the investor to understand
and analyze the performance
information better and better compare
the performance of funds and advisers
96 Proposed
rule 211(h)(1)–2(e)(2)(iii).
also Marketing Release, supra at footnote
61 (discussing clear and prominent disclosures in
the context of advertisements).
97 See
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without having to access other ancillary
documents. As a result, investors should
receive it as part of the quarterly
statement itself.
We request comment on this aspect of
the proposal:
• Should we require advisers to
disclose the criteria used and
assumptions made in calculating the
performance as part of the quarterly
statement as proposed? Is this approach
too flexible? Should we instead
prescribe required disclosures?
• Should we require advisers to
provide these disclosures prominently
as proposed? Is there another disclosure
standard we should use for these
purposes?
• Because we propose to require an
adviser to provide these disclosures as
part of each quarterly statement,
investors would receive these
disclosures quarterly. Would providing
these disclosures every quarter reduce
their salience? Should we require these
disclosures only as part of the first
quarterly statement that an adviser
sends to an investor with amendments
if the criteria used or assumptions made
in calculating performance change?
Should we permit hyperlinking to these
disclosures after the initial quarterly
statement?
3. Preparation and Distribution of
Quarterly Statements
The proposed rule would require
quarterly statements to be prepared and
distributed to fund investors within 45
days after each calendar quarter end. We
believe quarterly statements would
provide fund investors with timely and
regular statements that contain
meaningful and comprehensive
information. We understand that most
private fund advisers currently provide
investors with quarterly reporting.98
For a newly formed private fund, the
proposed rule would require a quarterly
statement to be prepared and distributed
beginning after the fund’s second full
calendar quarter of generating operating
results. Many private funds may not
have performance information that is
readily available within the first several
months of operations. For example, a
private equity fund might not begin
investing until several months after the
fund’s formation because the adviser is
still identifying investments that align
with the fund’s strategy. As another
example, a hedge fund may hold initial
investor capital in cash or cash
equivalents, prior to commencing the
98 See also ILPA Fee Reporting Template
Guidance, Version 1.1 (Oct. 2016), at 6 (stating that
‘‘ILPA recommends that the Template is provided
on a quarterly basis within a reasonable timeframe
after the release of standard reports.’’).
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fund’s investment strategy. Accordingly,
we believe that the proposed
requirements for newly formed funds
would help ensure that investors receive
comprehensive information about the
adviser during the early stage of the
fund’s life. The reporting period for the
final quarterly statement would cover
the calendar quarter in which the fund
is wound up and dissolved.
We propose to require quarterly
statements to be distributed within 45
days after the calendar quarter end.
Based on our experience, we believe
advisers generally would be in a
position to prepare and deliver quarterly
statements within this period.
An adviser generally would satisfy the
proposed requirement to ‘‘distribute’’
the quarterly statements when the
statements are sent to all investors in
the private fund.99 However, the
proposed rule would preclude advisers
from using layers of pooled investment
vehicles in a control relationship with
the adviser to avoid meaningful
application of the distribution
requirement. Advisers to private funds
may from time to time establish special
purpose vehicles (‘‘SPVs’’) or other
pooled vehicles for a variety of reasons,
including facilitating investments by
one or more private funds that the
advisers manage. In circumstances
where an investor is itself a pooled
vehicle that is controlling, controlled
by, or under common control with the
adviser or its related persons (a ‘‘control
relationship’’), the adviser must look
through that pool (and any pools in a
control relationship with the adviser or
its related persons, such as in a masterfeeder fund structure), in order to send
to investors in those pools. Without
such a requirement, the adviser would
be essentially delivering the quarterly
statement to itself rather than to the
parties the quarterly statement is
designed to inform.100 Outside of a
control relationship, such as if the
private fund investor is an unaffiliated
fund of funds, this same concern is not
99 See proposed rule 211(h)(1)–1 (defining
‘‘distribute’’). For purposes of the proposed rules,
any ‘‘in writing’’ requirement could be satisfied
either through paper or electronic means consistent
with existing Commission guidance on electronic
delivery of documents. See Marketing Release,
supra footnote 61, at n.346. If any distribution is
made electronically for purposes of these proposed
rules, it should be done in accordance with the
Commission’s guidance regarding electronic
delivery. See Use of Electronic Media by Broker
Dealers, Transfer Agents, and Investment Advisers
for Delivery of Information; Additional Examples
Under the Securities Act of 1933, Securities
Exchange Act of 1934, and Investment Company
Act of 1940, Release No. 34–37182 (May 9, 1996)
[61 FR 24644 (May 15, 1996)].
100 See proposed rule 211(h)(1)–1 (defining
‘‘control’’).
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present, and the adviser would not need
to look through the structure to make
meaningful delivery. The adviser would
just distribute the quarterly statement to
the adviser or other designated party of
the unaffiliated fund of funds. We
believe that this approach would lead to
meaningful delivery of the quarterly
statement to the private fund’s
investors.
We request comment on the quarterly
statement preparation and distribution
requirement of the proposed rule:
• Should we require advisers to
prepare and distribute statements to
clients at least quarterly, or should we
prescribe a different frequency? For
example, should we require monthly,
semi-annual, or annual statements?
Should we mandate the same delivery
frequency for all proposed statements
under the rule? How would each of
these approaches affect comparability
and effectiveness of the information in
those statements? Would a quarterly
reporting obligation require advisers to
value the fund’s investments more
frequently than advisers currently do?
• We understand that advisers may
use a fund administrator or another
person to distribute the quarterly
statement. Is the proposed definition of
‘‘distribute’’ broad enough to capture a
fund administrator or another person
acting under the direction and control of
the adviser sending the quarterly
statement on the adviser’s behalf? If not,
should we broaden the definition?
Instead of changing the definition of
‘‘distribute,’’ should we require the
adviser to distribute the quarterly
statement, unless it has reason to
believe that another person has
distributed a required statement (and
has a copy of each such statement
distributed by such other person)?
• The proposed rule would require
advisers to distribute the quarterly
statement within 45 days of a calendar
quarter end. Is this period too long or
too short for an adviser to prepare the
quarterly statement while also ensuring
timely delivery to investors? Should we
instead adopt a flexible delivery
standard, such as a requirement that the
adviser distribute the quarterly
statement ‘‘promptly’’? Why or why
not? If we were to adopt a prompt
delivery standard, should we define
‘‘promptly’’? If so, how? If we should
not define ‘‘promptly,’’ should we
instead interpret that term to mean as
soon as reasonably practicable?
• We understand that preparing
quarterly statements may require
coordination with, and reliance on,
third parties. This may be the case, for
example, when a private fund itself
invests in other private funds or
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portfolio companies. Should the rule
allow different distribution timelines for
different types of private funds (e.g.,
fund of funds, master feeder funds)? If
so, why (e.g., do certain types of funds
value assets more frequently than other
types)? Should the proposed rule allow
different distribution deadlines for
underlying funds, depending on
whether or not the underlying funds
have the same adviser or an adviser that
is a related person of the adviser
distributing the quarterly statements?
• Should the proposed rule bifurcate
the timing of when certain information
in the quarterly statement is required?
For example, should the proposed rule
require fee and expense information
starting at the fund’s inception and then
require performance information
beginning later? If so, when should we
require an adviser to start showing
performance?
• Should the proposed rule treat
liquid and illiquid funds differently
with regard to fee and expense versus
performance reporting? For example,
should the proposed rule require liquid
funds to start distributing quarterly
statements with performance reporting
sooner than illiquid funds? If so, why
and how much sooner?
• As proposed, the rule would use
‘‘operating results’’ as the trigger for
quarterly statement distribution. Should
we instead rely on another trigger to
indicate when an adviser must start
distributing quarterly statements to
investors? For example, should the
proposed rule instead require an adviser
to start distributing quarterly statements
when the private fund has financial
statements that report operating results?
If so, why? Should we define ‘‘operating
results’’ or clarify what it means?
• Should the proposed rule require an
adviser to prepare and distribute an
initial quarterly statement sooner than
after the first two full calendar quarters
of operating results? For example,
should we require an adviser to prepare
and distribute a quarterly statement
after the first calendar quarter of the
fund’s operations? Why or why not? If
we required an adviser to prepare and
distribute a quarterly statement earlier
in the fund’s life, would this
information be useful to investors?
• The proposed rule would require
advisers to prepare and distribute a
quarterly statement after the private
fund has two full calendar quarters of
operating results and continuously each
calendar quarter thereafter. An adviser
would be required to provide
information for any stub periods that
precede its first two full calendar
quarters of operating results (i.e., from
the date of the fund’s inception to the
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beginning of the first calendar quarter
during which the fund begins to
produce operating results). Should the
proposed rule explicitly address how
advisers should handle stub periods? If
so, how?
• The proposed rule would require
fee and expense reporting based on a
fund’s calendar quarter and
performance reporting based on a liquid
fund’s calendar year. Should we instead
use ‘‘fiscal quarter’’ and ‘‘fiscal year’’?
Why or why not?
• Are there certain types of advisers
or funds that should be exempt from
distributing the quarterly statement to
investors? If so, which ones and why?
Are there certain types of advisers or
funds that should be required to
distribute quarterly statements to
investors? If so, which ones and why?
• Instead of requiring advisers to
distribute the quarterly statement to
investors, should we require advisers to
only distribute or make the quarterly
statement available to investors upon
request? Despite the limitations of
private fund governance mechanisms, as
discussed above, should we require
advisers to distribute the quarterly
statement to independent members of
the fund’s LPAC, board, or other similar
governance body?
• Rule 206(4)–2 under the Advisers
Act (the ‘‘custody rule’’) allows a client
to designate an independent
representative to receive on its behalf
account statements and notices that are
required by that rule.101 Under the
custody rule, an ‘‘independent
representative’’ is defined as someone
who does not control, is not controlled
by, and is not under common control
with the adviser, among other
requirements.102 Should we adopt a
similar provision in the quarterly
statement rule? Are there specific types
of investors that need, or at present
commonly designate, independent
representatives to receive quarterly
statements on their behalf?
• Should we revise the definition of
‘‘distribute’’ expressly to include
distribution by granting investors access
to a virtual data room containing the
quarterly statement? Why or why not?
• We considered requiring the
proposed quarterly statement
disclosures to be submitted using a
structured, machine-readable data
language. Such format may facilitate
comparisons of quarterly statement
disclosures across advisers and periods.
Should we require advisers to provide
101 See
rule 206(4)–2(a)(7) under the Advisers
Act.
102 See
rule 206(4)–2(d)(4) under the Advisers
Act.
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16909
quarterly statements in a machinereadable data language, such as Inline
eXtensible Business Reporting Language
(‘‘Inline XBRL’’)? Why or why not?
Would such a requirement make the
quarterly statements, and the
information included therein, easier for
investors to analyze? For example,
would it be useful for investors to
download quarterly statement
information directly into spreadsheets,
particularly for institutional investors
that may have a significant number of
private fund investments? Would a
machine-readable data language impose
undue additional costs and burdens on
advisers? Please provide support for
your response, including, where
available, cost data.
• If we adopt rules requiring a
machine-readable data language, is the
Inline XBRL standard the one that we
should use? Are any other standards
becoming more widely used or
otherwise superior to Inline XBRL?
What would the advantages of any such
other standards be over Inline XBRL?
4. Consolidated Reporting for Certain
Fund Structures
An adviser may form multiple funds
to implement a single strategy. For
example, an adviser may form a parallel
fund for certain tax-sensitive investors,
such as non-U.S. investors that prefer to
invest through an entity taxed as a
corporation—rather than a
partnership—for U.S. Federal income
tax purposes, that invests alongside the
main fund in all, or substantially all, of
its investments. An adviser may also
form a feeder fund for tax-sensitive
investors that invests all, or
substantially all, of its capital into the
main fund. Advisers often seek to
structure the funds in a way that
accommodates investor preferences.
In some of these circumstances, we
believe that consolidated reporting of
the cost and performance information
by all private funds in the structure
would provide a more complete and
accurate picture of the fees and
expenses borne and performance
achieved than reporting by each private
fund separately. Due to the complexity
of private fund structures, however, we
believe a principles-based approach to
the funds that must provide
consolidated reporting is necessary.
Accordingly, the proposed rule would
require advisers to consolidate reporting
for substantially similar pools of assets
to the extent doing so would provide
more meaningful information to the
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private fund’s investors and would not
be misleading.103
For example, certain private funds
utilize master-feeder structures.
Typically, investors invest in onshore
and offshore feeder funds, which, in
turn, invest all, or substantially all, of
their investable capital in a single
master fund. The same adviser typically
advises and controls all three funds, and
the master fund typically makes and
holds the investments. Because the
feeder funds are conduits for investors
to gain exposure to the master fund and
its investments, the proposed rule
would require the adviser to provide
feeder fund investors with a single
quarterly statement covering the
applicable feeder fund and the feeder
fund’s proportionate interest in the
master fund on a consolidated basis, so
long as the consolidated statement
would provide more meaningful
information to investors and would not
be misleading.
We request comment on the proposed
consolidated reporting provision of the
proposed rule:
• Do commenters agree that the
proposed rule should require advisers to
consolidate reporting to cover related
funds to the extent doing so would
provide more meaningful information to
investors and would not be misleading?
Alternatively, should we prohibit
advisers from consolidating information
for multiple funds? Why or why not?
Should the rule permit, rather than
require, consolidated reporting?
• Should we require advisers to
provide a consolidated quarterly
statement for funds that are part of the
same strategy, such as parallel funds,
feeder funds, and master funds?
Alternatively, should these types of
funds have separate reporting? For
example, should feeder fund investors
receive a quarterly statement covering
the feeder fund and a separate quarterly
statement covering the main fund or
master fund? How should the rule
address the fact that certain funds may
have different expenses (e.g., an offshore
fund may have director expenses while
an onshore fund may not)? Should we
require advisers to provide investors
with a summary of any fund-specific
expenses and the corresponding dollar
amount(s)? Should such a requirement
be triggered only if the fund-specific
expense exceeds a certain threshold,
such as a percentage of the fund size
(e.g., .01%, .05%, or .10% of the fund’s
size) or a specific dollar amount (e.g.,
$15,000, $30,000, or $50,000)?
103 See proposed rule 211(h)(1)–2(f). See also
infra Section II.E.
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• As noted above, the proposal would
require advisers to provide feeder fund
investors with a consolidated quarterly
statement covering the applicable feeder
fund and the feeder fund’s
proportionate interest in the master
fund, to the extent doing so would
provide more meaningful information to
investors and would not be misleading.
Do commenters agree with this
approach? Alternatively, should we
require advisers to provide consolidated
reporting covering all feeder funds (and
not just the applicable feeder fund) and
the master fund? Why or why not?
• We also recognize that certain
private funds have multiple classes (or
other groupings such as series or
tranches) of interests or shares. The
proposed rule would require the
quarterly statement to present fundwide information. Would advisers face
challenges in calculating fee, expense,
and performance information if there
are differences in fees, allocations, and/
or expenses between or among classes,
series, or tranches? Should we require
disclosure of class-specific fees and
expenses, or of the differences among
classes? Why or why not? Should we
instead permit or require quarterly
statements for multi-class private funds
to present the proposed fee and expense
and performance information on a classby-class basis, particularly if each class
(or series or tranche) is considered a
distinct private fund or separate legal
entity (with segregated assets and
liabilities) under applicable law? Would
such an approach provide more
meaningful information for investors in
each of those classes, given the potential
for different fee, allocation, and expense
structures? Should we require quarterly
statements for multi-class (or multiseries or multi-tranche) private funds to
present class-by-class (or series-byseries or tranche-by-tranche)
information to the extent each class (or
series or tranche) holds different
investments?
• Should advisers only be required to
distribute a class’ quarterly statement to
interest holders of such class, or should
all fund investors be entitled to receive
such statement regardless of whether
they are interest holders of the relevant
class if the rule permits or requires
class-specific quarterly statements for
multi-class private funds?
• Certain advisers provide combined
financial statements covering multiple
funds. Should we require or permit
advisers to provide consolidated
quarterly statements for funds that have
combined financial statements? Why or
why not?
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5. Format and Content Requirements
The proposed rule would require the
adviser to use clear, concise, plain
English in the quarterly statement.104
For example, an adviser would not
satisfy the proposed requirement for
‘‘clear’’ disclosures unless those
disclosures are made in a font size and
type that is legible, and margins and
paper size (if applicable) are reasonable.
Likewise, to meet this standard, any
information that an adviser chooses to
include in a quarterly statement, but
that is not required by the rule, would
be required to be as short as practicable,
not more prominent than the required
information, and not obscure or impede
an investor’s understanding of the
mandatory information.
In addition, the proposed rule would
require an adviser to present
information in the quarterly statement
in a format that facilitates review from
one quarterly statement to the next. As
noted above, the quarterly statement is
designed to allow an investor to monitor
and assess the costs and performance of
the fund over time. We anticipate that,
quarter-over-quarter, an adviser would
use a consistent format for a fund’s
quarterly statements, thus allowing an
investor to easily compare fees,
expenses, and performance over each
quarterly period. We also encourage
advisers to use a structured, machinereadable format if advisers believe this
format would be useful to the investors
in their fund.
The proposed format and content
requirements would apply to all aspects
of a quarterly statement, including the
proposed requirements to disclose the
manner in which expenses, payments,
allocations, rebates, waivers, and offsets
are calculated and to cross-reference
sections of the private fund’s
organizational and offering
documents.105 We believe this approach
would improve the utility of the
quarterly statement by making it easier
for investors to review and analyze.
These requirements would support an
investor’s ability to understand needed
context provided in the quarterly
statement regarding fees, expenses, and
performance that allows investors to
monitor their investments. For example,
providing investors with clear and
easily accessible cross-references to the
fund governing documents would make
it easier for the investor to monitor
whether the fees and expenses in the
quarterly statement comply with the
fund’s governing documents.
We believe the proposal strikes an
appropriate balance in prescribing the
104 Proposed
105 Proposed
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content of the tables and performance
information to be included in quarterly
statements while taking a fairly
principles-based approach to format.
This would help provide investors with
standardized information about their
private fund investments, while
affording advisers some flexibility to
present the required information
without being overly prescriptive or
sacrificing readability. We considered,
but are not proposing, to further
standardize format, because we
recognize this might result in investor
confusion if an adviser includes
inapplicable line items to satisfy our
form requirements, while omitting
additional relevant information that
might be unique to a particular fund.
Moreover, we were concerned that
advisers would be unable to report on
a consolidated basis if we further
prescribed the format of the statements.
We request comment on this aspect of
the proposed rule:
• Should the proposed quarterly
statement rule include a provision on
formatting and content? Why or why
not?
• Do commenters agree with the
flexibility of the proposed format and
content requirements, or should we
prescribe wording? For example, should
we require a cover page with prescribed
wording? If so, what prescribed wording
should we require?
• To meet the rule’s formatting
requirements, any information that an
adviser chooses to include in a quarterly
statement, but that is not required by the
rule, would be required to be presented
in a manner that is no more prominent
than the required information. Should
the rule, instead, require that advisers
more prominently present information
that is required by the proposed
quarterly statement rule (as opposed to
supplemental information that is merely
permitted)? If an adviser chooses to
include supplemental information,
should we require that adviser to
disclose what information in the
quarterly statement is required versus
that which is voluntary?
6. Recordkeeping for Quarterly
Statements
We propose amending rule 204–2 (the
‘‘books and records rule’’) under the
Advisers Act to require advisers to
retain books and records related to the
proposed quarterly statement rule.106
106 For all of the recordkeeping rule amendments
in this proposed rulemaking package, advisers
would be required to maintain and preserve the
record in an easily accessible place for a period of
not less than five years from the end of the fiscal
year during which the last entry was made on such
record, the first two years in an appropriate office
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These proposed amendments would
help facilitate the Commission’s
inspection and enforcement capabilities.
First, we propose to require private fund
advisers to retain a copy of any
quarterly statement distributed to fund
investors pursuant to the proposed
quarterly statement rule, as well as a
record of each addressee, the date(s) the
statement was sent, address(es), and
delivery method(s). Second, we propose
to require advisers to retain all records
evidencing the calculation method for
all expenses, payments, allocations,
rebates, offsets, waivers, and
performance listed on any quarterly
statement delivered pursuant to the
proposed quarterly statement rule.
Third, advisers would be required to
make and keep books and records
substantiating the adviser’s
determination that the private fund it
manages is a liquid fund or an illiquid
fund pursuant to the proposed quarterly
statement rule. We believe these
proposed requirements would facilitate
our staff’s ability to assess an adviser’s
compliance with the proposed rule and
would similarly enhance an adviser’s
compliance efforts.107
We request comment on the proposed
recordkeeping rule amendments:
• Should we require advisers to
maintain the proposed records or would
these requirements be overly
burdensome for advisers? Are there
alternative or additional recordkeeping
requirements we should impose?
• Should we require advisers to retain
a record of each addressee, the date(s)
the statement was sent, address(es), and
delivery method(s) for each quarterly
statement, as proposed? Should we
instead eliminate this requirement
because of the potential burdens?
• Should we provide more specific
requirements regarding the records an
adviser must maintain to substantiate its
determination that a private fund is a
liquid fund or an illiquid fund?
Alternatively, should we leave the
proposed rule as is and allow advisers
flexibility in how they document this
determination?
B. Mandatory Private Fund Adviser
Audits
In addition to disclosure, we propose
to require private fund advisers to
obtain an annual audit of the financial
of the investment adviser. See rule 204–2(e)(1)
under the Advisers Act.
107 Advisers already are required to retain
performance calculation information under the
existing books and records rule and therefore would
be required to retain the performance calculation
information required as part of the proposed
quarterly statement rule. See rule 204–2(a)(16)
under the Advisers Act (requiring advisers to retain
performance calculation information).
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16911
statements of the private funds they
manage.108 In addition to providing
protection for the fund and its investors
against the misappropriation of fund
assets, we believe an audit by an
independent public accountant would
provide an important check on the
adviser’s valuation of private fund
assets, which often serve as the basis for
the calculation of the adviser’s fees.
The proposed audit rule would
require a registered investment adviser
providing investment advice, directly or
indirectly, to a private fund, to cause
that fund to undergo a financial
statement audit that meets the terms of
the rule at least annually and upon
liquidation, unless the fund otherwise
undergoes such an audit. Under the
proposed rule:
(1) The audit must be performed by an
independent public accountant that
meets the standards of independence in
17 CFR 210.2–01(b) and (c) (rule 2–01(b)
and (c) of Regulation S–X) that is
registered with, and subject to regular
inspection as of the commencement of
the professional engagement period, and
as of each calendar year-end, by, the
Public Company Accounting Oversight
Board (‘‘PCAOB’’) in accordance with
its rules;
(2) The audit must meet the definition
of audit in 17 CFR 210.1–02(d) (rule 1–
02(d) of Regulation S–X), the
professional engagement period of
which shall begin and end as indicated
in Regulation S–X rule 2–01(f)(5);
(3) Audited financial statements must
be prepared in accordance with U.S.
Generally Accepted Accounting
Principles (‘‘U.S. GAAP’’) or, in the case
of financial statements of private funds
organized under non-U.S. law or that
have a general partner or other manager
with a principal place of business
outside the United States (‘‘foreign
private funds’’), must contain
information substantially similar to
statements prepared in accordance with
U.S. GAAP and material differences
with U.S. GAAP must be reconciled;
(4) Promptly after completion of the
audit, the private fund’s audited
financial statements, which include any
reconciliation to U.S. GAAP prepared
for a foreign private fund, are
distributed; and
(5) The auditor notifies the
Commission upon certain events.109
Additionally, for a fund that the
adviser does not control and that is
neither controlled by nor under
108 Proposed rule 206(4)–10. The proposed rule
would apply to all investment advisers registered,
or required to be registered, with the Commission.
109 Proposed rule 206(4)–10; proposed rule
211(h)(1)–1 (defining ‘‘control’’ and ‘‘distributed’’).
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common control with the adviser (e.g.,
where an unaffiliated sub-adviser
provides services to the fund), such
adviser would only need to take all
reasonable steps to cause the fund to
undergo an audit that would meet these
elements.
We have historically relied on
financial statement audits to verify the
existence of pooled investment vehicle
investments.110 Financial statement
audits also provide additional
meaningful protections to private fund
investors by increasing the likelihood
that fraudulent activity or problems
with valuation are uncovered, thereby
providing deterrence against fraudulent
conduct by fund advisers. For example
as noted above, a fund’s adviser may use
a high level of discretion and
subjectivity in valuing a private fund’s
illiquid investments, which are difficult
to value. This creates a conflict of
interest if the adviser also calculates its
fees as a percentage of the value of the
fund’s investments and/or an increase
in that value (net profit), as is typically
the case. Moreover, private fund
advisers often rely heavily on existing
fund performance when obtaining new
investors (in the case of a private fund
that makes continuous or periodic
offerings) or fundraising for a new fund.
These factors raise the possibility that
funds are valued opportunistically and
that the adviser’s compensation may
involve fraud or deception, resulting in
an inappropriate compensation
scheme.111 A fund audit includes the
evaluation of whether the fair value
110 See, e.g., rule 206(4)–2(b)(4) under the
Advisers Act; Custody of Funds or Securities of
Clients by Investment Advisers, Investment
Advisers Act Release No. 2176 (Sept. 25, 2003) [68
FR 56692 (Oct. 1, 2003)] (‘‘Custody Release’’)
(providing advisers to certain pooled investment
vehicles with an exception to the surprise
examination requirement if the pooled investment
vehicles undergo an audit). Not all advisers are
subject to the custody rule and even those that are
subject to the custody rule are not required to
obtain an audit in order to comply with the rule.
111 See generally Jenkinson, Sousa, Stucke, How
Fair are the Valuations of Private Equity Funds?
(2013), available at https://www.psers.pa.gov/
About/Investment/Documents/PPMAIRC%202018/
27%20How%20Fair%20are%20the
%20Valuations%20of%20Private%20Equity
%20Funds.pdf. See also In the Matter of Swapnil
Rege, Investment Advisers Act Release No. 5303
(July 18, 2019) (settled action) (alleging that an
employee of a private fund adviser mispriced the
private fund’s investments, which resulted in the
adviser charging the fund excess management fees);
SEC v. Southridge Capital Mgmt., LLC, Lit. Rel. No.
21709 (Oct. 25, 2010) (alleging that adviser
overvalued the largest position held by the funds
by fraudulently misstating the acquisition price of
the assets); see docket for SEC v. Southridge Capital
Mgmt., LLC, U.S. District Court, District of
Connecticut (New Haven), case no. 3:10–CV–01685
(on September 12, 2016 the court granted the SEC’s
motion for summary judgment and entered a final
judgment in favor of the SEC in 2018).
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estimates and related disclosures are
reasonable and consistent with the
requirements of the financial reporting
framework (e.g., U.S. GAAP), which
may include evaluating the selection
and application of methods, significant
assumptions, and data used by the
adviser in making the estimate.112 We
believe that this would provide a critical
set of additional protections by an
independent third party.
The proposed audit rule is based on
the custody rule and contains many
similar or identical requirements,
although compliance with either rule
would not automatically satisfy the
requirements of the other.113 Although
the financial statement audit performed
under either rule would be the same,
there are several differences between the
two rules. The most notable difference
between the two rules is the lack of
choice about obtaining an audit under
the proposed audit rule. Under the
custody rule, an adviser is deemed to
have satisfied that rule’s annual surprise
examination requirement for a pooled
investment vehicle client if that pool is
subject to an annual financial statement
audit by an independent public
accountant, and its audited financial
statements (prepared in accordance with
generally accepted accounting
principles) are distributed to the pool’s
investors. Accordingly, an adviser may
obtain a surprise examination under the
custody rule instead of an audit. Private
fund advisers complying with the
proposed audit rule would not have a
similar choice; they must obtain an
audit. Based on our experience since
introducing the custody rule’s audit
provision, we have come to believe that
audits provide substantial benefits to
private funds and their investors
because audits test assertions associated
with the investment portfolio (e.g.,
completeness, existence, rights and
obligations, valuation, presentation).
Audits may also provide a check against
adviser misrepresentations of
performance, fees, and other
information about the fund.
Accordingly, the proposed audit rule
would require registered private fund
advisers, including those that currently
opt to undergo a surprise examination
for custody rule compliance purposes,
to have their private fund clients
undergo a financial statement audit.
Another main difference between the
requirements of the two rules is the
requirement of the proposed rule for
112 See American Institute of Certified Public
Accountants’ (‘‘AICPA’’) auditing standards, AU–C
Section 540 and PCAOB auditing standards, AS
2501.
113 See rule 206(4)–2(b)(4) under the Advisers
Act.
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there to be a written agreement between
the adviser or the private fund and the
auditor pursuant to which the auditor
would be required to notify our Division
of Examinations upon the auditor’s
termination or issuance of a modified
opinion.114 There is not a similar
obligation under the custody rule for an
adviser that relies on the audit provision
to satisfy the surprise examination
requirement. Our experience in
receiving similar information from
accountants who perform surprise
examinations under the custody rule
has led us to conclude that timely
receipt of this information—from an
independent third party—would more
readily enable our staff to identify
advisers potentially engaged in harmful
misconduct and who have other
compliance issues.115 This also would
aid the Commission in its oversight of
private fund advisers.
The other main difference between
the two rules, aside from timing
requirements for the distribution of
audited financial statements under the
two rules discussed below, relates to
their scope. While both rules pertain to
advisers that are registered or required
to be registered with us, the custody
rule also contains exceptions from the
surprise examination requirement,
which in turn make it unnecessary for
an adviser to rely on that rule’s audit
provision.116 In light of the different
policy goals of these two rules, we are
not proposing a parallel exception to the
proposed audit rule. Moreover, in our
experience, private fund advisers
generally do not often rely on these
exceptions. The proposed audit rule
does, however, contain an exception in
certain contexts where the adviser takes
all reasonable steps to cause an audit, as
described and for reasons discussed
below, which does not exist in the
custody rule.
1. Requirements for Accountants
Performing Private Fund Audits
The proposed audit rule would
include certain requirements regarding
the accountant performing a private
fund audit. First, we propose to require
an accountant performing a private fund
audit to meet the standards of
114 See proposed rule 206(4)–10(e). See AICPA
auditing standard, AU–C Section 705, which
establishes three types of modified opinions: A
qualified opinion, an adverse opinion, and a
disclaimer of opinion.
115 See rule 206(4)–2(a)(4)(iii) (requiring
somewhat similar information in the context of a
surprise examination).
116 See rule 206(4)–2(b)(3) and (6) (providing
exceptions from the surprise examination
requirement for fee deduction and where the
adviser has custody solely because a related person
has custody of a client’s funds or securities).
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independence described in rule 2–01(b)
and (c) of Regulation S–X in support of
the Commission’s long-standing
recognition that an audit by an
objective, impartial, and skilled
professional contributes to both investor
protection and investor confidence.117
Second, the proposed rule would
require the independent public
accountant performing the audit to be
registered with, and subject to regular
inspection as of the commencement of
the professional engagement period, and
as of each calendar year-end, by, the
PCAOB in accordance with its rules.
Based on our experience with the
custody rule, we believe registration and
the periodic inspection of an
independent public accountant’s system
of quality control by the PCAOB provide
investors with confidence in the quality
of the audits produced under the
proposed rule.
We understand that this requirement
may limit the pool of accountants that
are eligible to perform these services
because only those accountants that
currently conduct public company
issuer audits are subject to regular
inspection by the PCAOB. Most private
funds, however, are already undergoing
a financial statement audit; therefore,
the increase in demand for these
services may be limited.118 Nonetheless,
the resulting competition for these
services might increase costs to
investment advisers and investors.
We understand that, as part of a
temporary inspection program, the
PCAOB inspects accountants auditing
brokers and dealers, and identifies and
addresses with these firms any
significant issues in those audits.119
Similar to the inspection program for
issuer audits, we believe that the
temporary inspection program for
broker-dealers provides valuable
oversight of these accountants, resulting
in better quality audits. Accordingly, we
would consider an accountant’s
compliance with the PCAOB’s
temporary inspection program for
auditors of brokers and dealers to satisfy
117 See Revision of the Commission’s Auditor
Independence Requirements, Release No. 33–7919
(Nov. 21, 2000) [65 FR 76008 (Dec. 5, 2000)]. The
custody rule requires all accountants performing
services to meet the standards of independence
described in rule 2–01(b) and (c) of Regulation S–
X. See rule 206(4)–2(d)(3) under the Advisers Act.
118 For example, more than 90 percent of the total
number of hedge funds and private equity funds
currently undergo a financial statement audit. See
infra Section V.B.4.
119 See PCAOB Adopts Interim Inspection
Program for Broker-Dealer Audits and Broker and
Dealer Funding Rules (June 14, 2011) (‘‘temporary
inspection program’’), available at https://
pcaobus.org/News/Releases/Pages/06142011_
OpenBoardMeeting.aspx. See also Dodd-Frank Act
Section 982.
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the requirement for regular inspection
by the PCAOB under the proposed
independent public accountant
engagements provision until the
effective date of a permanent program
for the inspection of broker and dealer
auditors that is approved by the
Commission.120
An independent public accounting
firm would not be considered to be
‘‘subject to regular inspection’’ if it is
included on the list of firms that is
headquartered or has an office in a
foreign jurisdiction that the PCAOB has
determined it is unable to inspect or
investigate completely because of a
position taken by one or more
authorities in that jurisdiction in
accordance with PCAOB Rule 6100.121
We recognize that there may be a
limited number of PCAOB-registered
and inspected independent public
accountants in certain foreign
jurisdictions. However, we do not
believe that advisers would have
significant difficulty in finding an
accountant that is eligible under the
proposed rule in most jurisdictions
because many PCAOB-registered
independent public accountants who
are subject to regular inspection
currently have practices in various
jurisdictions, which may ameliorate
concerns regarding offshore availability.
2. Auditing Standards for Financial
Statements
Under the proposed audit rule, an
audit must meet the definition in rule
1–02(d) of Regulation S–X. Pursuant to
that definition, financial statement
audits performed for purposes of the
proposed audit rule would generally be
performed in accordance with the
generally accepted auditing standards of
the United States (‘‘U.S. GAAS’’).122
120 Our staff took a similar position and has had
several years to observe the impact on the
availability of accountants to perform services and
the quality of services produced by these
accountants. See Robert Van Grover Esq., Seward &
Kissel LLP, SEC Staff No-Action Letter (Dec. 11,
2019) (extending the no-action position taken in
prior letters until the date that a PCAOB-adopted
permanent program, having been approved by the
Commission, takes effect).
121 See, e.g., HFCAA Determination Report
Pursuant to 15 U.S.C. 7214(i)(2)(A) and PCAOB
Rule 6100 (Dec. 16. 2021), PCAOB Release No. 104–
HFCAA–2021–001, available at 104-hfcaa-2021001.pdf (azureedge.net) (publishing such list of
firms as of December 2021).
122 Under the definition in rule 1–02(d) of
Regulation S–X, an ‘‘audit’’ of an entity (such as a
private fund) that is not an issuer as defined in
section 2(a)(7) of the Sarbanes-Oxley Act of 2007
means an audit performed in accordance with
either the generally accepted auditing standards of
the United States (‘‘U.S. GAAS’’) or the standards
of the PCAOB. When conducting an audit of
financial statements in accordance with the
standards of the PCAOB, however, the auditor
would also be required to conduct the audit in
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U.S. GAAS requires that an auditor
evaluate and respond to the risk of
material misstatements of the financial
statements due to fraud or error.123
Among other benefits of this standard,
audits performed in accordance with
U.S. GAAS would help detect valuation
irregularities or errors, as well as an
investment adviser’s loss,
misappropriation, or misuse of client
investments. The proposed rule would
require the professional engagement
period of an audit performed under the
rule to begin and end as indicated in
Regulation S–X rule 2–01(f)(5).124
3. Preparation of Audited Financial
Statements
The proposed rule also generally
would require the audited financial
statements to be prepared in accordance
with U.S. GAAP. Financial statements
of private funds organized under nonU.S. law or that have a general partner
or other manager with a principal place
of business outside the United States
would be required to contain
information substantially similar to
statements prepared in accordance with
U.S. GAAP and any material differences
would be required to be reconciled to
U.S. GAAP. Requiring that financial
statements comply with U.S. GAAP is
designed to help investors receive
consistent and quality financial
reporting on their investments from the
fund’s adviser.
Financial statements that are prepared
in accordance with accounting
standards other than U.S. GAAP, would
meet the requirements of the proposed
audit rule so long as they contain
information substantially similar to
financial statements prepared in
accordance with U.S. GAAP, material
differences with U.S. GAAP are
reconciled, and the reconciliation,
accordance with U.S. GAAS because the audit
would not be within the jurisdiction of the PCAOB
as defined by the Sarbanes-Oxley Act of 2002, as
amended, (i.e., not an issuer, broker, or dealer). See
AICPA auditing standards, AU–C Section 700.46.
We believe most advisers would choose to perform
the audit pursuant to U.S. GAAS only rather than
both standards, though it would be permissible
under the proposed audit rule to perform the audit
pursuant to both standards.
123 See AICPA auditing standards, AU–C Section
240. Audits performed under PCAOB standards
provide similar benefits. See PCAOB auditing
standards, AS 2401, which discusses consideration
of fraud in a financial statement audit.
124 Among other things, rule 2–01(f)(5) of
Regulation S–X indicates that the professional
engagement period begins at the earlier of when the
accountant either signs an initial engagement letter
(or other agreement to review or audit a client’s
financial statements) or begins audit, review, or
attest procedures; and the period ends when the
audit client or the accountant notifies the
Commission that the client is no longer that
accountant’s audit client.
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including supplementary U.S. GAAP
disclosures, is distributed to investors as
part of the audited financial
statements.125 We believe that this
approach would allow advisers
flexibility to provide investors with
financial statements that are prepared in
accordance with applicable accounting
standards. We believe a reconciliation to
U.S. GAAP is necessary for private fund
audits because U.S. GAAP, has industry
specific accounting principles for
certain pooled vehicles, including
private funds.126 As a result, there could
be material differences between other
accounting standards and U.S. GAAP,
for example in the presentation of a
trade/settlement date, schedule of
investments and financial highlights,
that we would require to be reconciled.
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4. Prompt Distribution of Audited
Financial Statements
The proposed audit rule would
require a fund’s audited financial
statements to be distributed to current
investors ‘‘promptly’’ after the
completion of the audit.127 The audited
financial statements would consist of
the applicable financial statements
(including any required reconciliation
to U.S. GAAP, including supplementary
U.S. GAAP disclosures), related
schedules, accompanying footnotes, and
the audit report. We considered but are
not proposing to require the audited
financials to be distributed within 120
days of a private fund’s fiscal year end,
similar to the approach under the
custody rule. Based on our experience
administering the custody rule, we
believe that a 120-day time period is
generally appropriate to allow the
financial statements of an entity to be
audited and to provide investors with
timely information. We also understand,
however, that preparing audited
financial statements for some
arrangements, such as fund of funds
arrangements, may require reliance on
third parties, which could cause an
adviser to fail to meet the 120-day
timing requirements for distributing
audited financial statements regardless
of actions it takes to meet the
125 Proposed rule 206(4)–10(c) and (d). See also
Custody Release, supra footnote 110, at n.41 (stating
that an adviser may use such financial statements
to qualify for the audit exception from the custody
rule with respect to pools that have a place of
organization outside the United States or a general
partner or other manager with a principal place of
business outside the United States, if such financial
statements contain information that is substantially
similar to financial statements prepared in
accordance with U.S. GAAP and contain a footnote
reconciling any material variations between such
comprehensive body of accounting standards and
U.S. GAAP).
126 See U.S. GAAP ASC 946.
127 Proposed rule 206(4)–10(d).
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requirements. We also recognize there
may be times when an adviser
reasonably believes that a fund’s
audited financial statements would be
distributed within the required
timeframe but fails to have them
distributed in time under certain
unforeseeable circumstances. For
example, during the COVID–19
pandemic, some advisers were unable to
deliver audited financial statements in
the timeframes required under the
custody rule due to logistical
disruptions. Accordingly, and in light of
the fact that there is not an alternative
method by which to satisfy the
proposed rule as there is under the
custody rule (i.e., undergo a surprise
examination), we would require the
audited financial statements to be
distributed ‘‘promptly,’’ rather than
pursuant to a specific deadline. This
would provide some flexibility without
affecting investor protection.
Under the proposed audit rule, the
audited financial statements (including
any reconciliation to U.S. GAAP
prepared for a foreign private fund, as
applicable) must be sent to all of the
private fund’s investors. In
circumstances where an investor is itself
a pooled vehicle that is in a control
relationship with the adviser or its
related persons, it would be necessary to
look through that pool (and any pools in
a control relationship with the adviser
or its related persons, such as in a
master-feeder fund structure), in order
to send to investors in those pools.128
Without such a requirement, the audited
financial statements would essentially
be delivered to the adviser rather than
to the parties the financial statements
are designed to inform. Outside of a
control relationship, such as if the
private fund investor is an unaffiliated
fund of funds, this same concern is not
present, and it would not be necessary
to look through the structure to make
meaningful delivery. It would be
sufficient to distribute the audited
financial statements to the adviser to, or
other designated party of, the
unaffiliated fund of funds. We believe
that this approach would lead to
meaningful delivery of the audited
financial statements to the private
fund’s investors.
5. Annual Audit, Liquidation Audit, and
Audit Period Lengths
Key to the effectiveness of the audit
in protecting investors is timely and
regular administration and distribution.
Under the proposed audit provision, an
audit must be obtained at least annually
128 See
proposed rule 211(h)(1)–1 (defining
‘‘control’’ and ‘‘distribute’’).
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and upon an entity’s liquidation. The
liquidation audit would serve as the
annual audit for the fiscal year in which
it occurs. Requiring the audit on an
annual basis and at liquidation would
help alert investors within months,
rather than years, to any material
misstatements identified in the audit
and would raise the likelihood of
mitigating losses or reducing exposure
to other investor harms. Similarly, a
liquidation audit would help ensure the
appropriate and prompt accounting of
the proceeds of a liquidation so that
investors can take timely steps to
protect their rights at a time when they
may be vulnerable to misappropriation
by the investment adviser. We believe
that it becomes increasingly difficult to
correct a material misstatement the
longer it goes undetected. The proposed
annual and liquidation audit
requirements would address these
concerns while also balancing the cost,
burden, and utility of requiring frequent
audits.
The proposed annual audit
requirement is consistent with current
practices of private fund advisers that
obtain an audit in order to comply with
the custody rule under the Advisers Act,
or to satisfy investor demand for an
audit, and would provide investors with
uniformity in the information they are
receiving.129 When an investor receives
audited financial statements each year
from the same private fund, the investor
can compare statements year-over-year.
Additionally, the investor can analyze
and compare audited financial
statements across other private funds
and similar investment vehicles each
year. Further, we believe investors
expect audited financial statements to
include 12-month periods and rely on
this uniform period to review and
analyze financial statements year over
year for the same private fund.
With respect to liquidation, we
understand that the amount of time it
takes to complete the liquidation of a
private fund may vary. A number of
years might elapse between the decision
to liquidate an entity and the
completion of the liquidation process.
During this time, the fund may execute
few transactions and the total amount of
investments may represent a fraction of
the investments that existed prior to the
start of the liquidation process. We
further understand that a lengthy
liquidation period can lead to
circumstances where the cost of an
annual audit represents a sizeable
portion of the fund’s remaining assets.
129 As discussed above, differences between the
two rules are unrelated to the financial statement
audit itself.
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While we considered additional
modifications to the audit requirement
for a private fund during liquidation, we
are concerned that allowing for less
frequent auditing (e.g., every 18 months
or two years) during an entity’s
liquidation may expose investors to
abuse that could then go unnoticed for
prolonged periods. Furthermore, it is
our understanding that allowing for less
frequent auditing during liquidation—
for example, requiring an audit every
two years in such circumstances—may
not necessarily result in a meaningful
cost reduction to advisers or investors.
6. Commission Notification
The proposed rule would require an
adviser to enter into, or cause the
private fund to enter into, a written
agreement with the independent public
accountant performing the audit to
notify the Commission (i) promptly
upon issuing an audit report to the
private fund that contains a modified
opinion and (ii) within four business
days of resignation or dismissal from, or
other termination of, the engagement, or
upon removing itself or being removed
from consideration for being
reappointed.130 The accountant making
such a notification would be required to
provide its contact information and
indicate its reason for sending the
notification. The written agreement
must require the independent public
accountant to notify the Commission by
electronic means directed to the
Division of Examinations. Timely
receipt of this information would enable
our staff to evaluate the need for an
examination of the adviser. We expect
the Division of Examinations would
establish a dedicated email address to
receive these confidential transmissions
and would make the address available
on the Commission’s website in an
easily retrievable location.
As we noted above, there is not a
similar obligation under the custody
rule for an accountant to notify the
Commission as there is for a surprise
examination, although there is a
requirement on Form ADV for a private
fund adviser itself to report to the
Commission whether it received a
qualified audit opinion and to provide,
and update, its auditor’s identifying
information.131 However, our
experience in receiving notifications
from accountants who perform surprise
examinations under the custody rule
has led us to conclude that timely
receipt of this information—from an
independent third party—would more
readily enable our staff to identify
advisers potentially engaged in harmful
misconduct and who have other
compliance issues. This would bolster
the Commission’s efforts at preventing
fraudulent, deceptive, and manipulative
activity and would aid oversight of
private fund advisers.
7. Taking All Reasonable Steps To
Cause an Audit
We recognize that some advisers may
not have requisite control over a private
fund client to cause its financial
statements to undergo an audit in a
manner that would satisfy all five
elements (paragraphs (a) through (e)) of
the proposed rule. This could be the
case, for instance, where a sub-adviser
is unaffiliated with the fund. Therefore,
we are proposing to require that an
adviser take all reasonable steps to
cause its private fund client to undergo
an audit that would satisfy the rule, so
long as the adviser does not control the
private fund and is neither controlled by
nor under common control with the
fund.132 What would constitute ‘‘all
reasonable steps’’ would depend on the
facts and circumstances. For example, a
sub-adviser that has no affiliation to the
general partner of a private fund that
did not obtain an audit could document
the sub-adviser’s efforts by including (or
seeking to include) the requirement in
its sub-advisory agreement. On the
contrary, if the adviser is the primary
adviser to the fund, even if it is not the
general partner or a related person of the
general partner, it would likely not be
reasonable for the fund not to be audited
in accordance with the rule.
8. Recordkeeping Provisions Related to
the Proposed Audit Rule
Finally, the proposal would amend
the Advisers Act books and records rule
to require advisers to keep a copy of any
audited financial statements, along with
a record of each addressee and the
corresponding date(s) sent, address(es),
and delivery method(s) for each such
addressee.133 Additionally, the adviser
would be required to keep a record
documenting steps taken by the adviser
to cause a private fund client with
which it is not in a control relationship
to undergo a financial statement audit
that would comply with the rule. This
aspect of the proposal is designed to
facilitate our staff’s ability to assess an
adviser’s compliance with the proposed
audit rule and to detect risks the
proposed audit rule is designed to
address. We believe it would similarly
132 Proposed
rule 206(4)–10(f).
rule 204–2(a)(21). See also supra
footnote 106 (describing the record retention
requirements under the books and records rule).
133 Proposed
130 Proposed
131 Form
rule 206(4)–10(e).
ADV Part 1A, Section 7.B.1, Q.23.
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16915
enhance an adviser’s compliance efforts
as well.
We request comment on all aspects of
the proposed audit rule and related
proposed amendments to the books and
records rule, including the following
items:
• Would the proposed audit rule
provide appropriate protection for
investors? If not, please describe what,
if any, modifications would improve
investor protection.
• The proposed audit rule bears many
similarities to provisions of the custody
rule; however, one notable difference is
that there would be no option to,
instead, undergo a surprise examination
and rely on a qualified custodian to
deliver quarterly statements. What
would be the impact on advisers to
private funds that are not relying on the
custody rule’s audit provision? Are
private funds undergoing similar audits
of their financial statements for other
reasons, or would this represent a new
requirement for them? There also are no
exceptions from the proposed rule, as
there are in the custody rule, such as the
exception from the surprise examination
requirement for advisers whose sole
basis for being subject to the rule is
because they have authority to deduct
their advisory fees. What would be the
impact on advisers to private funds that
are relying on this and other exceptions?
Do many private fund advisers rely on
the exception for fee-deduction?
• Do commenters agree that the
similarities of the audit requirements for
the custody rule and for the proposed
rule would ease the compliance burdens
of advisers that would be required to
comply with both? Should the rule
provide that compliance with one rule
would satisfy the requirements of the
other, given the similarities of the two
rules? Why or why not?
• The application of the proposed
rule to registered advisers to private
funds seeks to balance our policy goal
with the anticipated costs of the
proposed measures. Do commenters
agree with this approach? If not, what
would be a more effective way of
achieving our goals?
• Should the rule apply to all
advisers to private funds, rather than to
just advisers to private funds that are
registered or are required to be
registered? Should it apply to exempt
reporting advisers? Why or why not?
• Similarly, should it apply in the
context of all pooled investment vehicle
clients (e.g., funds that rely on section
3(c)(5) of the Investment Company Act),
rather than just in the context of those
that meet the Advisers Act definition of
private fund? Should it apply more
broadly to any advisory account with
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financial statements that can be
audited? Why or why not?
• Should the rule provide any full or
partial exceptions, such as when an
adviser plays no role in valuing the
fund’s assets, receives little or no
compensation for its services, or
receives no compensation based on the
value of the fund’s assets? Should the
rule provide exceptions for private
funds below a certain asset threshold
(e.g., less than $5 million)? A higher or
lower amount? Should the rule provide
exemptions for private funds that have
only related person investors, or that
have a limited number of investors,
such as 5 or fewer investors? If yes,
please identify which advisers or funds
we should except, from which aspects
of the proposed audit rule, and why.
• Should the rule apply to a subadviser to a private fund? In situations
where a fund has multiple advisers, is
it clear that a single audit of the fund’s
financial statements may satisfy the
proposed audit rule for all of the
advisers subject to the rule?
• Should the alternative of ‘‘taking all
reasonable steps’’ to cause a private
fund client to be audited apply in any
situation, rather than just in situations
where the adviser is not in a control
relationship with its fund client? Why
or why not? Is it sufficiently clear how
an investment adviser can establish that
it has ‘‘taken all reasonable steps’’ to
cause a private fund client to obtain an
audit?
• Should the rule require accountants
performing the independent public
audits to be registered with the PCAOB,
as proposed? Should the rule limit the
pool of accountants to those who are
subject to inspection by the PCAOB, as
proposed? If the rule does not include
these requirements, should the rule
impose any alternative or additional
requirements on such accountants? If so,
describe these additional requirements
and explain why they are necessary or
appropriate.
• Do commenters agree that the
availability of accountants to perform
services for purposes of the proposed
audit rule is sufficient and that even
advisers in foreign jurisdictions (or with
private fund clients in foreign
jurisdictions) would not have significant
difficulty in finding a local accountant
that is eligible to perform an audit under
the proposed rule? Do advisers have
reasonable access to independent public
accountants that are registered with, and
subject to inspection by, the PCAOB in
the foreign jurisdictions in which they
operate? If not, how should the rule
address this issue?
• Should the rule require advisers to
obtain audits performed under rule 1–
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02(d) of Regulation S–X, as proposed? If
not, what other auditing standards
should the rule allow? Are there certain
non-U.S. auditing standards that the
proposed rule should explicitly
include?
• Should the rule require private
funds to prepare audited financial
statements in accordance with generally
accepted accounting principles, as
proposed? Should the rule include any
additional requirements regarding the
preparation of financial statements? If
so, what requirements, and why?
• As proposed, should financial
statements prepared in accordance with
accounting standards other than U.S.
GAAP for foreign private funds meet the
requirements of the rule provided they
contain information substantially
similar to statements prepared in
accordance with U.S. GAAP, material
differences with U.S. GAAP are
reconciled, and the reconciliation is
distributed to investors along with the
financial statements? If so, should we
specify what ‘‘substantially similar’’
means?
• Would there be unique challenges
to complying with the rule for auditors
and advisers to private funds in foreign
jurisdictions? For example, might
certain advisers or auditors face
challenges in complying with the
proposed rule’s Commission
notification requirement, including
because of applicable privacy and other
local laws? If so, what would alleviate
these challenges and still achieve the
policy goals of the proposed audit rule?
• Do commenters agree that the
proposed rule’s requirement to
distribute the audited financial
statements promptly would provide
appropriate flexibility regarding the
timing of the distribution of audited
financial statements? Should there
nevertheless be an outer limit on the
number of days an investment adviser
has from its fiscal year end for the
distribution of audited financial
statements? If so, what should that limit
be? Would it be more appropriate for
distribution to be required within 120
days of the end of the fund’s fiscal year,
as under the custody rule?
Alternatively, would a longer or shorter
period be appropriate in most
circumstances? Should the timeline for
distributing audited financial statements
align with the timeline for distributing
quarterly statements under the proposed
quarterly statement rule? Why or why
not? We understand that funds of funds
or certain funds in master-feeder
structures (including those advised by
related persons) have difficulty
satisfying the 120-day requirement and
that our staff has indicated they would
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not recommend enforcement if certain
of these funds satisfy the distribution
requirement within 180 or 260 days of
the fund’s fiscal year end, depending on
a variety of circumstances.134 If the rule
contained a specific distribution
deadline, would these types of funds
need a separate deadline or other
special treatment?
• Instead of requiring prompt
distribution of the audited financial
statement to investors, should we
require the statement to be distributed
or made available to investors upon
request?
• Should the rule provide additional
flexibility, such as for situations in
which the adviser can demonstrate that
it reasonably believed that it would be
able to comply with the rule but failed
due to certain unforeseeable
circumstances?
• Should the rule require annual
audits, as proposed? Should the rule
require an audit upon a private fund’s
liquidation, as proposed? Should we
modify either or both of these
requirements? If so, how should we
modify these requirements, and why?
• Advisers would be required to
comply with the proposed audit rule
beginning with their first fiscal year
after the compliance date and any
liquidation that occurs after the
compliance date. Advisers would also
be required to obtain an audit annually.
We understand that newly formed and
liquidating funds may face unique
challenges. For instance, the value
provided by an audit of a very short
period of time, such as a period of less
than three-months (a ‘‘stub period’’),
may be diminished because there is a
lack of comparability in the information
provided. In addition, we understand
that the cost of obtaining an audit
covering a few months can be similar to
the cost of an audit covering an entire
fiscal year. We further understand that
when newly formed entities have few
financial transactions and/or
investments, obtaining an audit, relative
to the investor protections ultimately
offered by obtaining the audit, may be
burdensome. Should the rule allow
newly formed or liquidating entities to
obtain an audit less frequently than
annually to avoid stub period audits?
Should the rule permit advisers to
satisfy the audit requirement by relying
on an audit on an interval other than
annually when a fund is liquidating?
For example, should we allow advisers
134 See generally Staff Responses to Questions
About the Custody Rule, available at https://
www.sec.gov/divisions/investment/custody_faq_
030510.htm.
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to rely on an audit of a fund every two
years during the liquidation process?
• If the rule were to permit audits less
frequently than on an annual basis,
should it also include additional
restrictions or requirements? If so, what
restrictions or requirements, and why?
For instance, should it require
investment advisers to create and
distribute alternative financial reporting
for the fund to investors (e.g., cash-flow
audit or asset verification)?
Alternatively, or in addition to
alternative financial reporting, should
the rule require advisers to obtain a
third-party examination? If so, what
should the examination consist of, and
why? For example, would allowing
advisers to obtain an audit less
frequently than annually during a
liquidation raise investor protection
concerns that additional requirements
could address given the potential for a
liquidation to last for an extended
period? If so, what additional
requirements, and why? For example,
should advisers be required to provide
notice to investors of their intent to
liquidate an entity in these
circumstances? Should advisers be
required to obtain investor consent prior
to satisfying the audit requirement by
relying on audits on a less than annual
basis? Should we set an outer limit for
the period such an audit could cover
(e.g., 15 months)?
• Should the rule define
‘‘liquidation’’ for purposes of the
liquidation audit requirement? If so,
how? For example, should we base such
a definition on a certain percentage of
assets under management of the entity
from or over previous fiscal period(s) or
a stated threshold based on an absolute
dollar amount of the entity’s assets
under management? Should we base the
definition on a calculation of the ratio
of the management fees assessed on
assets under management of the entity
or some other basis, for example, to
detect whether an adviser is charging
management fees on a very small
amount of assets?
• Are there risks posed to investors
when an entity is liquidating that the
proposed rule does not address? If so,
please describe those risks. How should
we modify the rule to address such
risks?
• Are there some types of investments
that pose a greater risk of
misappropriation or loss to investors
during a liquidation that the rule should
specifically address to provide greater
investor protection? If so, please
describe the investment type; the
particular risk the investment type
poses to investors during liquidation;
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and how to modify the proposed rule to
address such investor risk.
• We are not proposing the filing of
a copy of the audit report or a copy of
the audited financial statements with
the Commission; should the rule
contain such a requirement? Why or
why not?
• Would the requirement for an
accountant to comply with the
notification requirement change the
approach that an accountant would take
with respect to audits that normally are
performed for purposes of satisfying the
custody rule? If so, how?
• Should we, as proposed, require
advisers to enter into, or cause a private
fund to enter into, a written agreement
with the independent public accountant
completing the audit to notify the
Commission in connection with a
modified opinion or termination?
• Do commenters agree that the
professional engagement period of an
audit performed under the rule should
begin and end as indicated in
Regulation S–X rule 2–01(f)(5), as
proposed? If not, why not?
• As noted above, the proposed
Commission notification provision bears
some similarities to, and is drawn from
our experience with, a similar custody
rule requirement in the surprise
examination context with which we
believe advisers may likely already have
some familiarity. The regulations in 17
CFR 240.17a–5 (rule 17a–5) require a
broker or dealer’s self-report to the
Commission within one business day
and to provide a copy to the accountant.
The accountant must report to the
Commission about any aspects of the
broker or dealer’s report with which the
accountant does not agree. If the broker
or dealer fails to self-report, the
accountant must report to the
Commission to describe any material
weaknesses or any instances of noncompliance that triggered the
notification requirement. Should the
audit rule contain similar requirements?
Why or why not? Are private fund
advisers and the accountants that
perform private fund financial statement
audits more familiar with Rule 17a–5’s
notification requirement than the
custody rule’s notification requirement?
• Do commenters agree that the
related proposed amendments to the
books and records rule would facilitate
compliance with the proposed audit
rule? What additional or alternative
amendments should the rule include, if
any?
C. Adviser-Led Secondaries
We propose to require an adviser to
obtain a fairness opinion in connection
with certain adviser-led secondary
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transactions where an adviser offers
fund investors the option to sell their
interests in the private fund, or to
exchange them for new interests in
another vehicle advised by the adviser.
This would provide an important check
against an adviser’s conflicts of interest
in structuring and leading a transaction
from which it may stand to profit at the
expense of private fund investors. The
proposed adviser-led secondaries rule
would prohibit an adviser from
completing an adviser-led secondary
transaction with respect to any private
fund, unless the adviser distributes to
investors in the private fund, prior to
the closing of the transaction, a fairness
opinion from an independent opinion
provider and a summary of any material
business relationships the adviser or
any of its related persons has, or has had
within the past two years, with the
independent opinion provider.135
Investments in closed-end private
funds are typically illiquid and require
a long-term investor commitment of
capital. Such funds generally do not
permit investors to withdraw or redeem
their fund interests prior to the end of
the term. Open-end private funds may
also limit or restrict an investor’s ability
to withdraw or redeem its interest, for
example, with side pockets or illiquid
sleeves. Without the ability to cash out
all or a portion of their interest from the
fund, investors have historically sought
liquidity by selling their interests on the
secondary market to third parties.
Advisers typically have a relatively
minor role in such ‘‘investor-led’’
transactions, as investors engage in the
transaction directly with the prospective
purchaser.
In recent years, advisers have become
increasingly active in the secondary
market. The number of ‘‘adviser-led’’
transactions has increased, with the deal
value of such transactions representing
a meaningful portion of the secondary
market, particularly for closed-end
private funds.136 Adviser-led
transactions are similar to investor-led
transactions in that they typically
provide a mechanism for investors to
obtain liquidity; however, they also
135 Proposed rule 211(h)(2)–2. The proposed rule
would not apply to advisers that are not required
to register as investment advisers with the
Commission, such as state-registered advisers and
exempt reporting advisers.
136 See, e.g., Private Equity International, GP-Led
Secondaries Report (Feb. 28, 2021), available at
https://www.privateequityinternational.com/gp-ledsecondaries-report-2021/ (noting one industry
participant estimated that adviser-led secondary
transactions accounted for $26 billion (or 44% of
the secondary market) in 2020, while another
estimated that they accounted for more than $30
billion (or more than 50% of the secondary
market)).
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have the potential to provide additional
benefits to advisers and investors. For
example, an adviser-led transaction may
seek to secure additional capital and/or
time to maximize the value of fund
assets. An adviser may accomplish this
by permitting investors to ‘‘roll’’ their
interests into a new vehicle that has a
longer term and/or additional capital to
invest.137
Adviser-led secondaries often are
highly bespoke transactions that can
take many forms. For purposes of the
rule, we propose to define them as
transactions initiated by the investment
adviser or any of its related persons that
offer the private fund’s investors the
choice to: (i) Sell all or a portion of their
interests in the private fund; or (ii)
convert or exchange all or a portion of
their interests in the private fund for
interests in another vehicle advised by
the adviser or any of its related
persons.138 We generally would
consider a transaction to be initiated by
the adviser if the adviser commences a
process, or causes one or more other
persons to commence a process, that is
designed to offer private fund investors
the option to obtain liquidity for their
private fund interests. However,
whether the adviser or its related person
initiates a secondary transaction
requires a facts and circumstances
analysis. We would generally not view
a transaction as initiated by the adviser
if the adviser, at the unsolicited request
of the investor, assists in the secondary
sale of such investor’s fund interest.
This definition generally would
include secondary transactions where a
fund is selling one or more assets to
another vehicle managed by the adviser,
if investors have the option either to
obtain liquidity or to roll all or a portion
of their interests into the other vehicle.
Examples of such transactions may
include single asset transactions (such
as the fund selling a single asset to a
new vehicle managed by the adviser),
strip sale transactions (such as the fund
selling a portion of multiple assets to a
new vehicle managed by the adviser),
and full fund restructurings (such as the
fund selling all of its assets to a new
vehicle managed by the adviser). The
proposed definition also would capture
secondary transactions that may not
involve a cross sale between two
vehicles managed by the same
adviser.139 For example, an adviser may
137 An investor would typically obtain liquidity
in the event it elects to sell—rather than roll—its
fund interest.
138 Proposed rule 211(h)(1)–1.
139 We would not consider the proposed rule to
apply to cross sales where the adviser does not offer
the private fund’s investors the choice to sell,
convert, or exchange their fund interest.
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arrange for one or more new investors
to purchase fund interests directly from
the existing investors as part of a
‘‘tender offer’’ or similar transaction.
While adviser-led transactions can
provide liquidity for investors and
secure additional time and capital to
maximize the value of fund assets, they
also raise certain conflicts of interest.
The adviser and its related persons
typically are involved on both sides of
the transaction and have interests in the
transaction that are different than, or in
addition to, the interests of the private
fund investors. For example, because
the adviser may have the opportunity to
earn economic and other benefits
conditioned upon the closing of the
secondary transaction, such as
additional management fees or carried
interest, the adviser generally has a
conflict of interest in setting and
negotiating the transaction terms.
Ensuring that the private fund and the
investors that participate in the
secondary transaction are offered a fair
price is a critical component of
preventing the type of harm that might
result from the adviser’s conflict of
interest in leading the transaction.140
Accordingly, prior to the closing of the
transaction, the proposed rule would
require advisers to obtain a written
opinion stating that the price being
offered to the private fund for any assets
being sold as part of an adviser-led
secondary transaction is fair.141 This
process would provide an important
market check for private fund investors
by providing some assurance that the
price being offered is based on an
underlying valuation that falls within a
range of reasonableness. We understand
that certain advisers obtain fairness
opinions as a matter of best practice
because investors often lack access to
sufficient information, or may not have
the capabilities or resources, to conduct
their own analysis of the price.
However, to the extent that this practice
is not universal, the proposed rule
would mandate it in connection with all
adviser-led secondary transactions.
To mitigate the potential influence of
the adviser’s conflict of interest further,
the rule would require these opinions to
be issued only by an ‘‘independent
140 As a fiduciary, the adviser is obligated to act
in the fund’s best interest and to make full and fair
disclosure to the fund of all conflicts and material
facts associated with the adviser-led transaction.
See, e.g., Commission Interpretation Regarding
Standard of Conduct for Investment Advisers,
Investment Advisers Act Release No. 5248 (June 5,
2019) [84 FR 33669 (July 12, 2019)], at 24–25 (‘‘2019
IA Fiduciary Duty Interpretation’’). See also
EXAMS Private Funds Risk Alert 2020, supra
footnote 9.
141 Proposed rule 211(h)(1)–1 (defining ‘‘fairness
opinion’’).
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opinion provider,’’ which is one that (i)
provides fairness opinions in the
ordinary course of its business and (ii)
is not a related person of the adviser.142
The ordinary course of business
requirement would largely correspond
to persons with the expertise to value
illiquid and esoteric assets based on
relevant criteria. The requirement that
the opinion provider not be a related
person of the adviser would reduce the
risk that certain affiliations could result
in a biased opinion.143
We recognize, however, that other
business relationships may have the
potential to result, or appear to result,
in a biased opinion, particularly if such
relationships are not disclosed to
private fund investors. For example, an
opinion provider that receives an
income stream from an adviser for
performing services unrelated to the
issuance of the opinion might not want
to jeopardize its business relationship
with the adviser by alerting the private
fund investors that the price being
offered is unfair (or by otherwise
refusing to issue the fairness opinion).
By requiring disclosure of such material
relationships, the proposed rule would
put private fund investors in a position
to evaluate whether any conflicts
associated with such relationships may
cause the opinion provider to deliver a
biased opinion. Thus, the proposed rule
would require the adviser to prepare
and distribute to private fund investors
a summary of any material business
relationships the adviser or any of its
related persons has, or has had within
the past two years, with the
independent opinion provider. Whether
a business relationship would be
material under the proposed rule would
require a facts and circumstances
analysis; however, for purposes of the
proposed rule, we believe that audit,
consulting, capital raising, investment
banking, and other similar services
would typically meet this standard.
The proposed rule would require an
adviser to distribute the opinion and the
material business relationship summary
to investors.144 We believe that this
proposed requirement would ensure
that investors receive the benefit of an
independent price assessment, which
we believe will improve their decisionmaking ability and their overall
confidence in the transaction.
We request comment on all aspects of
the proposed rule, including the
following items:
142 Proposed
rule 211(h)(1)–1.
supra section II.A for a discussion of the
definition of ‘‘related person.’’
144 Proposed rule 211(h)(2)–2.
143 See
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• Do commenters agree that adviserled secondary transactions can be of
some benefit to a private fund and its
investors?
• Do commenters agree with the
scope of the proposed rule? Should the
rule apply to all investment advisers?
Why or why not? What are the factors
that weigh in favor of expanding the
scope of the proposed rule to apply to
a broader scope of advisers than
proposed? Are there particular types of
advisers that should or should not be
subject to the rule? Should the rule only
apply when the adviser or its related
person is general partner (or equivalent)
of a fund that is party to the transaction?
• Should certain adviser-led
transactions be exempt from the
proposed rule? For example, if the
adviser conducts a competitive sale
process for the assets being sold, which
ultimately leads to the price, should
advisers still be required to obtain a
fairness opinion? Do competitive bids
typically represent net asset value? Do
prospective purchasers typically bid at
a discount to net asset value? Does net
asset value always correspond to the
current value of the assets being sold?
Why or why not? Are there other price
discovery processes that we should
require to protect investors?
• Should certain adviser-led
transactions be exempt from the rule,
such as adviser-led transactions
involving liquid funds? For example, if
the underlying assets being sold in the
transaction are predominantly publicly
traded securities, should advisers still
be required to obtain a fairness opinion?
Do such transactions present the same
concerns as adviser-led secondary
transactions involving illiquid funds
where the underlying assets are
typically illiquid and not listed or
quoted on a securities exchange? Are
there other hedge fund transactions that
we should exempt from the rule, such
as hedge fund restructurings where an
adviser may be merging the portfolios of
two different hedge funds and gives all
affected investors the option to redeem
or convert/exchange their interests into
the new fund? Should the exemption
depend on whether the price of the
transaction is based on net asset value?
Why or why not?
• Are there other transactions for
which we should require private fund
advisers to obtain a fairness opinion?
For example, should we require advisers
to obtain a fairness opinion before
certain cross transactions between
private funds it manages? If so, which
transactions? Should we provide certain
cross transaction exemptions, such as
exemptions for bridge financings or
syndications where the selling fund
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transfers the investments within a short
period at a price equal to cost plus
interest?
• Should the scope of the fairness
opinion be limited to the price, as
proposed? Alternatively, should we
require the fairness opinion to cover all,
or certain other, terms of the
transaction? For example, should we
revise the definition of ‘‘fairness
opinion’’ to a written opinion stating
that the terms of the adviser-led
secondary transaction are fair to the
private fund? Why or why not?
• Should the rule give investment
advisers the option to obtain either a
fairness opinion or a third-party
valuation? Why or why not? What are
the advantages and disadvantages of a
third-party valuation as compared to a
fairness opinion, and vice versa?
• We request comment on the
proposed use of ‘‘related person.’’ Do
commenters agree that the fairness
opinion should be issued by a person
that is not a related person of the
adviser? Should we adopt a different
definition of ‘‘related person’’ than the
one proposed?
• The proposed rule would require an
‘‘independent opinion provider’’ to
provide fairness opinions ‘‘in the
ordinary course of its business.’’ Do
commenters agree with this approach?
• Instead of requiring disclosure of
any material business relationships
between the adviser (or its related
persons) and the independent opinion
provider, should the rule prohibit firms
with certain business relationships with
the adviser, its related persons, or the
private fund from providing the fairness
opinion? For example, if a firm has
provided consulting, prime broker,
audit, capital raising, or investment
banking services to the private fund or
the adviser or its related persons within
a certain time period—such as two or
three years—should the rule prohibit
the firm from providing the opinion? If
so, should the rule include a threshold
of materiality, regularity, or frequency
for some or all of such services to trigger
such a prohibition?
• Should we require the independent
opinion provider to have any specific
qualifications, licenses, or registrations?
• Should we define the term
‘‘transaction’’ in the definition of
‘‘adviser-led secondary transaction’’? If
so, how should the rule define
‘‘transaction’’? Should we reference the
various types of adviser-led secondary
transactions in the definition? For
example, should ‘‘transaction’’ include
only single asset transactions, strip sale
transactions, and other similar
secondary transactions? Should we
include in the definition of ‘‘adviser-led
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secondary transaction’’ transactions
initiated by the adviser’s related
persons?
• Should we define, or provide
additional guidance regarding, the
phrase ‘‘initiated by the investment
adviser or any of its related persons’’?
Should we define, or provide additional
guidance regarding, the role the adviser
would have to play in a secondary
transaction for it to be considered an
adviser-led transaction subject to the
proposed rule?
• Should the rule require the fairness
opinion to state that the private fund
and/or its investors may rely on the
opinion? Why or why not?
• Should we require the fairness
opinion to be obtained on behalf of the
private fund as proposed? Alternatively,
should we require the fairness opinion
to be obtained on behalf of the private
fund investors? Are there characteristics
of certain types of adviser-led
transactions, such as tender offers, that
would require the fairness opinion to be
obtained on behalf of the private fund
investors rather than the private fund?
• Should the adviser be required to
distribute a summary of any material
business relationships the adviser or its
related persons has, or has had within
the past two years, with the
independent opinion provider as
proposed? Should we provide guidance
or impose requirements regarding the
level of detail advisers should include
in the summary? For example, should
we require advisers to disclose the total
amount paid to the independent
opinion provider by the adviser or its
related persons, if applicable? Why or
why not? Is two years the appropriate
look-back period? Are there any other
conflict disclosures we should require
in the fairness opinion or otherwise
require to be made available to
investors?
• Should we define ‘‘material
business relationship’’ for purposes of
the proposed rule? Should the rule
include a threshold of regularity or
frequency (in addition to or in lieu of
the materiality threshold) for some or all
of such relationships or services to
trigger a disclosure requirement?
• Should we require advisers to
distribute the fairness opinion to
investors as proposed? Alternatively,
should we require advisers to only
distribute or make the fairness opinion
available to investors upon request?
• We recognize that certain adviserled transactions may not involve
investors rolling their interests into a
new vehicle managed by the adviser.
For example, an adviser may arrange for
a new investor to offer to purchase fund
interests directly from existing
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investors, such as a tender offer. Do
commenters agree that the first prong of
the definition would cover such
transactions? Should the rule treat such
transactions differently?
• Should the rule apply to adviser-led
transactions initiated by the adviser or
its related persons as proposed? Is the
definition of ‘‘related person’’ too broad
in this context such that it would
capture secondary transactions initiated
by third parties unrelated to the adviser?
Should we revise the definition of
‘‘related person’’ to include an
investment discretion requirement?
Similarly, is the definition of ‘‘control’’
too broad in this context?
• We recognize that, for certain
adviser-led transactions, the closing of
the underlying deal may not occur
simultaneously with the closing of the
new vehicle managed by the adviser.
How should the rule take this into
account, if at all? For example, should
we clarify that, for purposes of the rule,
an adviser would not be deemed to have
completed an adviser-led secondary
transaction until the underlying deal
has closed (if applicable)? Alternatively,
should we prohibit an adviser from
calling investor capital prior to
obtaining and distributing the fairness
opinion?
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1. Recordkeeping for Adviser-Led
Secondaries
We propose amending rule 204–2
under the Advisers Act to require
advisers to retain books and records to
support their compliance with the
proposed adviser-led secondaries rule,
which would help facilitate the
Commission’s inspection and
enforcement capabilities. We propose to
require advisers to retain a copy of the
fairness opinion and material business
relationship summary distributed to
investors, as well as a record of each
addressee, the date(s) the opinion was
sent, address(es), and delivery
method(s).145 These proposed
requirements would facilitate our staff’s
ability to assess an adviser’s compliance
with the proposed rule and would
similarly enhance an adviser’s
compliance efforts.
We request comment on this aspect of
the proposed rule:
• Should we require advisers to
maintain the proposed records or would
these requirements be overly
burdensome for advisers? Are there
alternative or additional recordkeeping
requirements we should impose?
145 See supra footnote 106 (describing the record
retention requirements under the books and records
rule).
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• Should we require advisers to retain
a record of each addressee, the date(s)
the statement was sent, address(es), and
delivery method(s) as proposed? Why or
why not?
D. Prohibited Activities
We are also proposing to prohibit a
private fund adviser from engaging in
certain sales practices, conflicts of
interest, and compensation schemes that
are contrary to the public interest and
the protection of investors. We have
observed certain industry practices over
the past decade that have persisted
despite our enforcement actions and
that disclosure alone will not
adequately address.146 As discussed
below, we believe that these sales
practices, conflicts of interest, and
compensation schemes must be
prohibited in order to prevent certain
activities that could result in fraud and
investor harm.147 We believe these
activities incentivize advisers to place
their interests ahead of their clients’
(and, by extension, their investors’), and
can result in private funds and their
investors, particularly smaller investors
that are not able to negotiate preferential
deals with the adviser and its related
persons, bearing an unfair proportion of
fees and expenses. The proposed rule
would prohibit these activities
regardless of whether the private fund’s
governing documents permit such
activities or the adviser otherwise
discloses the practices and regardless of
whether the private fund investors (or
governance mechanisms acting on their
behalf, such as limited partner advisory
committees) have consented to the
activities either expressly or implicitly.
Also, the proposed rule would prohibit
these activities even if they are
performed indirectly, for example by an
adviser’s related persons, because the
activities have an equal potential to
harm the fund and its investors
regardless of whether the adviser
engages in the activity directly or
indirectly.148 As noted above, we
believe these prohibitions are necessary
given the lack of governance
mechanisms that would help check
overreaching by private fund advisers.
146 See High-End Bargaining Problems, Vanderbilt
Law Review (forthcoming), Professor William
Clayton (Jan. 8, 2022) at 9 (challenging ‘‘the idea
that sophisticated parties will demand appropriate
levels of disclosure and appropriate processes
without any intervention by policymakers . . .’’).
147 See sections 206 and 211(h)(2) of the Act.
148 Any attempt to avoid any of the proposed
rules’ restrictions, depending on the facts and
circumstances, would violate section 208(d) of the
Act’s general prohibitions against doing anything
indirectly which would be prohibited if done
directly. Section 208(d) of the Advisers Act.
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Proposed rule 211(h)(2)–1 would
prohibit an investment adviser to a
private fund, directly or indirectly, from
engaging in certain activities with
respect to the private fund or any
investor in that private fund, including:
(i) Charging certain fees and expenses
to a private fund or portfolio
investment, including accelerated
monitoring fees; fees or expenses
associated with an examination or
investigation of the adviser or its related
persons by governmental or regulatory
authorities; regulatory or compliance
expenses or fees of the adviser or its
related persons; or fees and expenses
related to a portfolio investment on a
non-pro rata basis when multiple
private funds and other clients advised
by the adviser or its related persons
have invested (or propose to invest) in
the same portfolio investment;
(ii) Reducing the amount of any
adviser clawback by the amount of
certain taxes;
(iii) Seeking reimbursement,
indemnification, exculpation, or
limitation of its liability by the private
fund or its investors for a breach of
fiduciary duty, willful misfeasance, bad
faith, negligence, or recklessness in
providing services to the private fund;
and
(iv) Borrowing money, securities, or
other fund assets, or receiving an
extension of credit, from a private fund
client.
This proposed rule would apply to all
advisers to private funds, regardless of
whether they are registered with the
Commission or one or more states,
exempt reporting advisers, or prohibited
from registration. We believe that this
scope is appropriate since we believe
these activities are contrary to the
public interest and the protection of
investors and have the potential to lead
to fraud. We are proposing this rule
under sections 206 and 211 of the
Advisers Act, which sections apply to
all investment advisers, regardless of
SEC-registration status.
We request comment on the scope of
the proposed rule, including the
following items:
• Should the rule apply to all
advisers as proposed? Alternatively,
should the rule apply only to SECregistered advisers? If so, why?
• Should the rule only prohibit these
activities with respect to an adviser’s
private fund clients and the investors in
those private funds? Should the rule
apply more broadly or more narrowly?
For example, should the rule apply to
such activities with respect to all clients
of an adviser? Should the rule apply to
such activities with respect to persons
to which the adviser offers co-
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investment opportunities even if the
adviser does not classify them as its
clients?
• We have historically taken the
position that most of the substantive
provisions of the Advisers Act do not
apply with respect to the non-U.S.
clients (including funds) of a registered
offshore adviser.149 In taking this
approach, the Commission noted that
U.S. investors in an offshore fund
generally would not expect the full
protection of the U.S. securities laws
and that U.S. investors may be
precluded from an opportunity to invest
in an offshore fund if their participation
would result in full application of the
Advisers Act and rules thereunder.150
Similarly, the proposed prohibited
activities rule would not apply to a
registered offshore adviser’s private
funds organized outside of the United
States, regardless of whether the private
funds have U.S. investors. Do
commenters agree that registered
offshore advisers should not be subject
to this rule with respect to their offshore
private fund clients or offshore
investors? Should other rules in this
rulemaking package take the same
approach, or a different approach, with
respect to a registered offshore adviser’s
offshore private fund clients? Please
explain.
• Instead of prohibiting these
activities, should the rule prohibit these
activities unless the adviser satisfies
certain governance and other conditions
(e.g., disclosure to investors in all
relevant funds/vehicles, approval by the
limited partner advisory committee (or
other similar body) or directors)?
Should the rule prohibit these activities
unless the adviser obtains approval for
them by a majority (by number and/or
in interest) of investors? Should the rule
permit non pro-rata fee and expense
allocations if such practice is disclosed
to, and consented by, co-investors?
• Should we amend the books and
records rule to require advisers to retain
specific documentation evidencing
compliance with the prohibited
activities rule? For example, records
showing how fees and expenses
associated with an examination or
investigation of the adviser or its related
persons by governmental or regulatory
authorities were paid or showing the
149 See, e.g., Exemptions for Advisers to Venture
Capital Funds, Private Fund Advisers With Less
Than $150 Million in Assets Under Management,
and Foreign Private Advisers, Investment Advisers
Act Release No. 3222 (June 22, 2011) [76 FR 39645
(July 6, 2011)]; Marketing Release, supra footnote
61, at n.199.
150 See Registration Under the Advisers Act of
Certain Hedge Fund Advisers, Investment Advisers
Act Release No. 2333 (Dec. 2, 2004) [69 FR 72054,
72072 (Dec. 10, 2004)].
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other hand. For example, the adviser
receives the benefit of the accelerated
fees without incurring any costs
associated with having to provide any
services. The private fund, however,
may have a lower return on its
investment because the accelerated
monitoring fees may reduce the
portfolio investment’s available cash, in
turn reducing the investment’s value in
advance of a public offering or sale
transaction. An adviser also may have
an incentive to cause the fund to exit a
1. Fees for Unperformed Services
portfolio investment earlier than
First, the prohibited activities rule
anticipated, which may result in the
would prohibit an investment adviser
fund receiving a lesser return on its
from charging a portfolio investment for investment.154 Further, the potential for
monitoring, servicing, consulting, or
the adviser to receive these economic
other fees in respect of any services the
benefits creates an incentive for the
investment adviser does not, or does not adviser to seek portfolio investments for
reasonably expect to, provide to the
its own benefit rather than for the
portfolio investment.151 These payments fund’s. We believe prohibiting this
sometimes are referred to as
practice, which distorts the economic
‘‘accelerated payments.’’
relationship between the private fund
An adviser typically receives
and the adviser, would help prevent the
management fees and performanceadviser from placing its own interests
based compensation for providing
ahead of the private fund.
advisory services to a fund. A fund’s
In addition to these conflicts, we
portfolio investments may also make
believe
that charging a portfolio
payments to the adviser and its related
investment
for unperformed services
persons. For example, some private
creates
a
compensation
scheme that is
fund advisers enter into arrangements
contrary
to
the
public
interest
and the
with a fund’s portfolio investments to
protection
of
investors
because
such
provide management, consulting,
practice
unjustly
enriches
the
adviser
at
financial, servicing, advisory, or other
the
expense
of
the
private
fund
and
its
services. The adviser and the applicable
underlying investors who are not
portfolio investment would enter into a
monitoring agreement or a management receiving the benefit of any services.
Accordingly, the proposed rule would
services agreement documenting the
prohibit an adviser from charging these
payment terms and the services the
types of accelerated payments.
152
adviser will provide.
Such
The prohibited activities rule would
agreements often include acceleration
not prohibit an adviser from receiving
clauses, which permit the adviser to
payment for services actually provided.
accelerate the unpaid portion of the fee
The proposed rule also would not
upon the occurrence of certain
prohibit an adviser from receiving
triggering events, even though the
payments in advance for services that it
adviser will never provide the
reasonably expects to provide to the
contracted for services.153 The
portfolio investment in the future. For
accelerated payments reduce the value
example, if an adviser expects to
of the portfolio investment upon the
provide monitoring services to a
private fund’s exit and thus reduce
portfolio investment, the proposed rule
returns to investors.
would not prohibit the adviser from
Because the private fund (and, by
charging for those services.155 Rather,
extension, its investors) typically bears
the proposed rule would prohibit
the costs of such payments indirectly
compensation schemes where an
and the adviser typically receives the
benefit, the receipt of such fees gives
154 Such incentive may be mitigated, in certain
rise to conflicts of interest between the
circumstances, to the extent the adviser’s
fund (and, by extension, its investors),
compensation would also be
on the one hand, and the adviser, on the performance-based
reduced in whole or part by the receipt of these
allocations of fees and expenses related
to a portfolio investment on an
investment by investment basis? Would
advisers be able to obtain or generate
sufficient records to demonstrate
compliance with all aspects of the
proposed rule? Should we amend the
books and records rule to require
advisers to prepare a memorandum on
an annual basis attesting to their
compliance with each aspect of the
proposed rule?
151 Proposed
rule 211(h)(2)–1(a)(1).
152 Monitoring fees frequently are based on a
percentage of EBITDA (earnings before income,
taxes, depreciation, and amortization). The
agreements often renew automatically and typically
include periodic fee increases.
153 Common triggering events include initial
public offerings, dispositions, and change of control
events.
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payments.
155 To the extent the adviser ultimately does not
provide the services, however, the proposed rule
would require the adviser to refund any prepaid
amounts attributable to the unperformed services.
See proposed rule 211(h)(2)–1(a)(1) (prohibiting an
adviser from charging a portfolio investment for
fees in respect of any services that the investment
adviser does not provide to the portfolio
investment).
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adviser charges for services that it does
not reasonably expect to provide.
We also do not intend to prohibit an
arrangement where the adviser shifts
100% of the economic benefit of any
portfolio investment fee to the private
fund investors, whether through an
offset, rebate, or otherwise. We
recognize that certain advisers offset
management fees or other amounts
payable to the adviser at the fund level
by the amount of portfolio investment
fees paid to the adviser. However,
private funds with a 100% management
fee offset would not comply with the
proposed rule if there are excess fees
retained by the adviser where no further
management fee offset can be applied
and the private fund investors are not
offered a rebate or another economic
benefit equal to their pro rata share of
any such excess fees.
We request comment on this aspect of
the prohibited activities rule, including
the following items:
• Are there any scenarios in which
we should permit an adviser to charge
a fund’s portfolio investment for
unperformed services? If so, please
explain.
• Should we prohibit an adviser from
being paid in advance for services it
reasonably expects to provide in the
future? Why or why not?
• As noted above, if an adviser is paid
in advance, and reasonably expects to
perform services, but ultimately does
not provide the contracted for services,
the proposed rule would require the
adviser to refund the prepaid amount
attributable to the unperformed services.
Do commenters agree with this
approach? Why or why not?
• The proposed rule specifically
references ‘‘monitoring, servicing,
consulting, or other fees.’’ Do
commenters agree with this list? Should
we eliminate any? Are there additional
or alternative types of remuneration that
the rule should reference?
• Do commenters agree that if an
adviser shifts 100% of the economic
benefit of any portfolio investment fee
to the private fund investors, whether
through an offset, rebate, or otherwise,
the adviser would not violate the
proposed rule? Why or why not? We
recognize that certain tax-sensitive
investors often waive the right to receive
their share of any rebates of portfolio
investment fees. How should the rule
take into account such waivers, if it all?
For example, to the extent one investor
does not accept its share, should the
rule require the adviser to distribute
such amount to the other investors in
the fund? Why or why not?
• Should the rule instead permit an
adviser to engage in this activity if the
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adviser satisfies certain disclosure,
governance, and/or other conditions
(e.g., disclosure to investors in all
relevant funds/vehicles, approval by the
LPAC (or other similar body) or
directors)?
• The proposed rule would prohibit
compensation schemes where an
adviser charges for services that it does
not reasonably expect to provide. Is
‘‘reasonably expect’’ the appropriate
standard? Should we provide examples
or guidance to assist advisers in
complying with this standard? Does this
standard have the potential to reduce
the effectiveness of the rule? Are there
other standards we should adopt?
2. Certain Fees and Expenses
The second and third elements of the
prohibited activities rule would prevent
an adviser from charging a private fund
for fees or expenses associated with an
examination or investigation of the
adviser or its related persons by any
governmental or regulatory authority, as
well as regulatory and compliance fees
and expenses of the adviser or its
related persons.156
Advisers incur various fees and
expenses in connection with the
establishment and ongoing operations of
their advisory business. Establishment
fees and expenses often relate to the
structuring and organization of the
adviser’s business, including the
adviser’s registration with financial
regulators, such as the Commission.
Ongoing fees and expenses often relate
to the adviser’s overhead and
administrative expenses, such as salary,
rent, and office supplies. Ongoing
expenses also may include those
associated with an examination or
investigation of the adviser or its related
persons.
The proposed rule would prohibit an
adviser from charging a private fund for
(i) fees and expenses associated with an
examination or investigation of the
adviser or its related persons by any
governmental or regulatory authority,
and (ii) regulatory or compliance fees
and expenses of the adviser or its
related persons, even where such fees
and expenses are otherwise disclosed.
We have seen an increase in private
fund advisers charging these expenses
to private fund clients. These types of
expenses, which are a cost of being an
investment adviser, should not be
passed on to private fund investors,
whether as a separate expense (in
156 Proposed rules 211(h)(2)–1(a)(2) and (3). This
prohibition would include fees and expenses
related to an examination or investigation of the
adviser by the Commission, including the amount
of any settlements or fines paid in connection
therewith.
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addition to a management fee) or as part
of a pass-through expense model.157 For
example, we believe advisers should
bear the compliance expenses related to
their registration with the Commission,
including fees and expenses related to
preparing and filing all items and
corresponding schedules in Form ADV.
Similarly, we believe that an adviser
should bear any expenses related to
state licensing and registration
requirements applicable to the adviser
and its related persons, including
expenses related to registration and
licensure of advisory personnel who
contact or solicit investments from state
pension or similar plans.
We believe allocating these types of
expenses to a private fund client is
contrary to the public interest and is
harmful to investors because they create
an incentive for an adviser to place its
own interests ahead of the private
fund’s interests and unfairly allocate
expenses to the fund, even where fully
disclosed. For example, in some
circumstances, an adviser may charge a
fund significant fees and expenses in
connection with an investigation that
may not be in the fund’s best interest.
Further, as discussed above, we believe
the prohibited fees and expenses are
related to forming and operating an
advisory business and thus should be
borne by the adviser and its owners
rather than the private fund and its
investors.
We do not anticipate this aspect of the
proposed prohibited activities rule
would cause a dramatic change in
practice for most private fund advisers,
other than for certain advisers that
utilize a pass-through expense model as
noted above. We recognize, however,
that advisers often charge private funds
for regulatory, compliance, and other
similar fees and expenses directly
related to the activities of the private
fund. The proposed rule would not
change this practice. For example, the
proposed rule would not prohibit an
adviser from charging a private fund for
all the costs associated with a regulatory
filing of the fund, such as Form D.158 In
addition, we acknowledge that it may
not be clear whether certain fees and
157 Certain private fund advisers utilize a passthrough expense model where the private fund pays
for most, if not all, expenses, including the adviser’s
expenses, but the adviser does not charge a
management, advisory, or similar fee. We recognize
that this aspect of the proposed rule would likely
require advisers that pass on the types of fees and
expenses we propose to prohibit to re-structure
their fee and expense model.
158 Advisers may be liable under the antifraud
provisions of the Federal securities laws if the
private fund’s offering and organizational
documents do not authorize such costs to be
charged to the private fund.
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expenses relate to the fund or the
adviser, or it may not be clear until after
a significant amount of time has passed
in certain cases. In these circumstances,
an adviser generally should allocate
such fees and expenses in a manner that
it believes in good faith is fair and
equitable and is consistent with its
fiduciary duty.
We request comment on this aspect of
the prohibited activities rule, including
the following items:
• Are there circumstances in which it
would be appropriate in the public
interest or for the protection of investors
for a private fund to bear (i) regulatory
or compliance expenses of the adviser
or its related persons or (ii) expenses
related to an examination or
investigation of the adviser or its related
persons? If so, please explain. Should
we permit private funds to bear these
fees and expenses if fully disclosed and
consented to by the private fund
investors and/or an LPAC (despite the
limitations of private fund governance
mechanisms, as discussed above)?
Should we place any conditions on
charging these fees and expenses, such
as caps, management fee offsets, or
detailed reporting requirements in the
proposed quarterly statement?
• The proposed rule would likely
increase operating costs for advisers that
have historically charged private funds
for the types of fees and expenses
covered by the proposed rules.
Do commenters believe that advisers
would increase management fees to
offset such increase in operating costs?
• Are there any additional types of
fees or expenses that we should prohibit
an adviser from charging to a private
fund? Alternatively, are there fees and
expenses that the rule should not
prohibit?
• Should we provide exceptions to
the proposed rules for certain types of
private funds and/or certain types of
advisers? For example, should we
permit a first-time fund adviser to
charge regulatory and compliance
expenses to the fund? If so, why?
• Do commenters agree that many
advisers do not currently charge private
funds for the types of fees and expenses
covered by the proposed rules and, as a
result, the proposed rules would not
cause a dramatic change in industry
practice? Why or why not? To the extent
commenters disagree, please provide
supporting data.
• Will advisers have difficulty in
determining whether fees and expenses
relate to the adviser’s activities versus
the fund’s activities? Should we provide
guidance to assist advisers in making
such a determination? If so, what
guidance should we provide? Should
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the rule list certain types of fees and
expenses that relate to the adviser’s
activities versus the fund’s activities?
• As discussed above, we recognize
that certain private fund advisers utilize
a pass-through expense model. Should
the rule provide any full or partial
exceptions for advisers utilizing such
models, particularly where the adviser
does not charge any management,
advisory, or similar fees to the private
fund?
3. Reducing Adviser Clawbacks for
Taxes
The fourth element of the prohibited
activities rule would prohibit an adviser
from reducing the amount of any
adviser clawback by actual, potential, or
hypothetical taxes applicable to the
adviser, its related persons, or their
respective owners or interest holders.
We propose to define ‘‘adviser
clawback’’ as any obligation of the
adviser, its related persons, or their
respective owners or interest holders to
restore or otherwise return performancebased compensation to the private fund
pursuant to the private fund’s governing
agreements.159 We propose to define
‘‘performance-based compensation’’ as
allocations, payments, or distributions
of capital based on the private fund’s (or
its portfolio investments’) capital gains
and/or capital appreciation.160
Investors typically seek to align their
interests with the adviser’s interest by
tying the adviser’s compensation to the
success of the private fund. To
accomplish this, many private funds
provide the adviser with a
disproportionate share of profits
generated by the fund, often referred to
as performance-based compensation.161
The adviser’s performance-based share
of fund profits is often greater than the
adviser’s ownership percentage in the
fund.162 Although the percentage can
vary, a common performance-based
compensation percentage is 20%,
meaning that, for each dollar of profit
generated by the fund, the adviser is
generally entitled to 20 cents and the
159 Proposed rule 211(h)(2)–1(a)(4). Because
performance-based compensation may be allocated
or granted to individuals and entities otherwise
unaffiliated with the adviser, the proposed
definition is drafted broadly to capture any owner
or interest holder of the adviser or its related
persons.
160 Proposed rule 211(h)(1)–1. The proposed rule
would not apply to any clawbacks by an adviser of
incentive compensation under an arrangement
subject to Section 956 of the Dodd-Frank Act and
regulations thereunder.
161 Certain private funds refer to performancebased compensation as carried interest, incentive
fees, incentive allocations, or profit allocations.
162 For alignment of interest purposes, advisers
often invest their own capital in the fund alongside
the third party capital.
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16923
fund investors are generally entitled to
the remaining 80 cents.
Because the profitability of a private
fund will fluctuate over time, the
amount of performance-based
compensation to which the adviser is
entitled will also fluctuate. For example,
a fund may initially generate significant
profits due to early realizations of
successful investments, resulting in
distributions to the adviser. However,
the fund may subsequently dispose of
unsuccessful investments, resulting in
losses to the fund. Certain private funds
include ‘‘clawback’’ mechanisms in
their governing agreements, which
require the adviser (or a related person
of the adviser) 163 to restore
distributions or allocations to the fund
to the extent the adviser receives
performance-based compensation in
excess of the amount to which it is
otherwise entitled under the fund’s
governing agreement. Typically, this
means that the adviser is required to
return to the fund distributions or
allocations representing more than a
specified percentage (e.g., 20%) of the
fund’s aggregate profits. The clawback
mechanism is intended to ensure that
the adviser and the investors ultimately
receive the appropriate split of
cumulative profits generated over the
life of the fund or the applicable
measurement period.
Advisers and investors often negotiate
whether the clawback amount should be
reduced by taxes paid, or deemed paid,
by the adviser or its owners.164 For
example, if an adviser received $10 of
‘‘excess’’ performance-based
compensation, but the adviser or its
owners paid $3 in taxes on such
amount, investors often argue that the
adviser should be required to return the
‘‘pre-tax’’ amount ($10), while advisers
argue that they should only be required
to return the ‘‘post-tax’’ amount ($7). To
support the post-tax position, advisers
often argue that they should only be
required to return the portion of excess
163 For tax and other reasons, a related person of
the adviser, rather than the adviser, often receives
the performance-based compensation from the
fund.
164 Fund agreements may require advisers to
restore performance-based compensation under
other fact patterns as well. For example, if an
adviser has received performance-based
compensation, but the investors have not received
the requisite preferred return amount, the adviser
may be subject to a clawback. Any such
requirement to restore or otherwise return
performance-based compensation under a private
fund’s governing agreement would be covered by
the proposed rule. See proposed rule 211(h)(1)–1
(defining ‘‘adviser clawback’’ as any obligation of
the adviser, its related persons, or their respective
owners or interest holders to restore or otherwise
return performance-based compensation to the
private fund pursuant to the private fund’s
governing agreements).
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distributions they ultimately retain (and
not the portion paid to any taxing
authority). Advisers also argue that, to
the extent the clawback occurs in any
year subsequent to the year in which the
performance-based compensation was
paid, it may be burdensome or
impractical for the adviser or its owners
to amend tax returns from prior years or
otherwise take advantage of loss
carryforwards for future tax years.165
We believe that reducing the amount
of any adviser clawback by taxes
applicable to the adviser puts the
adviser’s interests ahead of the
investors’ interests and creates a
compensation scheme that is contrary to
the public interest and the protection of
investors, even where such practice is
disclosed. The interests of investors to
receive their share of fund profits—
without any adviser tax reductions—
justifies the burdens on advisers,
including the obligation to amend tax
returns. Advisers typically have control
over the methodology used to determine
the timing of performance-based
compensation distributions or
allocations, such as any waterfall
arrangement.166 Advisers also typically
have control over whether the fund will
make a distribution or allocation of
performance-based compensation.
Advisers thus have discretion to defer or
otherwise delay payments, particularly
if the adviser is concerned about the
possibility of a clawback.167 Even if an
adviser cannot defer or delay a payment,
the adviser can escrow performance165 When the clawback occurs in a subsequent tax
year, the ‘‘excess’’ performance-based compensation
will likely have already been subject to tax in the
year it was paid, even if the amount subject to the
clawback is determined on a pre-tax basis.
166 Private fund investors often seek to negotiate
the waterfall arrangement, and the timing of
performance-based compensation distributions,
with the adviser. The issues relating to clawbacks
often arise in the context of a waterfall arrangement
that provides performance-based compensation to
the adviser on a deal-by-deal basis (or modified
versions thereof), versus a waterfall arrangement
that is applied across the whole-fund with
distributions going to investors until the investors
recoup 100% of their capital contributions and
receive a preferred return thereon. Both models
should generally result in the adviser and the
investors receiving the same split of fund profits
over the life of the fund assuming the fund
documents have a clawback mechanism. The main
distinction between the two models is the timing of
distributions or allocations of performance-based
compensation to the adviser. Whole-fund waterfalls
are often referred to in the private funds industry
as European waterfalls; deal-by-deal waterfalls are
often referred to as American waterfalls.
167 We recognize that an adviser (and its
personnel) may be subject to a tax obligation
whether or not the fund makes a distribution,
payment, or allocation of performance-based
compensation (e.g., tax allocations of income may
precede or follow cash payments of performancebased compensation), including if the adviser
places the performance-based compensation into
escrow.
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based compensation rather than making
a payment to its owners, which would
allow the adviser to cover all or a
portion of a clawback obligation that
may arise in the future. Accordingly, the
proposed rule would foster greater
alignment of interest between advisers
and investors by prohibiting advisers
from unfairly causing investors to bear
these tax costs associated with the
payment, distribution, or allocation of
‘‘excess’’ performance-based
compensation.
We request comment on this aspect of
the proposed rule, including the
following items:
• Would this aspect of the proposed
prohibited activities rule have our
intended effect of ensuring that
investors receive their full share of
profits generated by the fund? Is there
an alternative approach that would
better produce this intended effect? For
example, should we require advisers to
return the entire amount of any adviser
clawback, rather than only prohibiting
advisers from reducing the clawback
amount by actual, potential, or
hypothetical taxes? Would this
approach ensure that investors receive
their full share of fund profits?
• Would the proposed clawback
provision result in more whole-fund
waterfalls (commonly referred to as
European waterfalls in the private funds
industry), which generally delay
payments of performance-based
compensation until investors receive a
return of all capital contributions? What
other effects would this aspect of the
proposed rule have on the industry,
including with respect to adviser’s
ability to attract, retain, and develop
investment professionals?
• Instead of the proposed clawback
provision, should we prohibit deal-bydeal waterfall arrangements (commonly
referred to as American waterfalls)?
• We recognize that clawback
mechanisms are more common for
closed-end funds and less common for
open-end funds. Should the rule
separately address performance-based
compensation for open-end private
funds? If so, how should we address
those funds?
• Is the proposed definition of
‘‘adviser clawback’’ clear? Are there
ways in which the proposed definition
is over- or under-inclusive? For
example, should the definition include
‘‘all-partner’’ givebacks or clawbacks
(i.e., should advisers be prohibited from
reducing the portion of an all-partner
giveback attributable to their
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performance-based compensation by
taxes paid or deemed paid)?168
• Is the proposed definition of
‘‘performance-based compensation’’
clear? Is it too narrow or too broad?
• What issues may advisers face in
complying with this aspect of the
proposed prohibited activities rule? In
particular, what issues may result with
respect to amending tax returns from
prior years?
• We recognize that this aspect of the
proposed rule might result in delayed
payments of performance-based
compensation. For example, during the
early stages of the fund, the adviser may
be less inclined to distribute
performance-based compensation to
investment professionals that source or
manage successful investments. How
would this aspect of the proposed
prohibited activities rule affect the
intended incentive effects of
performance-based compensation?
• We recognize that many fund
agreements clawback performancebased compensation on a post-tax basis.
We considered, but are not proposing, a
rule that would generally allow this
practice to continue, but would prohibit
advisers from using a hypothetical
marginal tax rate to determine the tax
reduction amount.169 We considered
requiring advisers to use the actual
marginal tax rates applicable to the
adviser or its owners, rather than a
hypothetical marginal tax rate. Our view
is that this approach could be too
burdensome for advisers. Do
commenters agree? If we were to adopt
this approach, how should we factor tax
benefits realized by the adviser or its
owners into the tax reduction amount?
What operational challenges would
advisers face under this alternative
approach? For example, would the
amount of time it may take to determine
168 An ‘‘all-partner’’ giveback is typically a
requirement for all investors to return or otherwise
restore distributions to the fund. An adviser may
use this mechanism for the purpose of satisfying
fund obligations, liabilities, or expenses.
169 Because many entities that receive
performance-based compensation are fiscally
transparent for U.S. Federal income tax purposes
and thus not subject to entity-level taxes,
determining the actual taxes paid on ‘‘excess’’
performance-based compensation can be
challenging, particularly for larger advisers that
have not only a significant number of participants
that receive such compensation but also have
participants subject to non-U.S. tax regimes. To
address this problem, advisers typically use a
‘‘hypothetical marginal tax rate’’ to determine the
tax reduction amount, which is usually based on
the highest marginal U.S. Federal, state, and local
tax rates. Advisers argue that this approach is a
reasonable and cost-effective method for
determining the tax reduction amount; investors
argue that the hypothetical rate is too high and
therefore reduces the clawback amount to their
detriment.
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the actual tax amount, which may not
be determined until a significant
amount of time has passed not justify
the benefits? Do commenters believe
that the use of a hypothetical marginal
tax rate is a reasonable and costeffective method for determining the tax
reduction amount, or do commenters
believe that the hypothetical marginal
tax rate is too high? Why or why not?
Please provide data.
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4. Limiting or Eliminating Liability for
Adviser Misconduct
The fifth element of the proposed
prohibited activities rule would prohibit
an adviser to a private fund, directly or
indirectly, from seeking reimbursement,
indemnification, exculpation, or
limitation of its liability by the private
fund or its investors for a breach of
fiduciary duty, willful misfeasance, bad
faith, negligence, or recklessness in
providing services to the private fund.
Currently, many private funds and/or
their investors enter into documents
containing such contractual terms. Our
staff has observed private fund
agreements with waiver and
indemnification provisions that have
become more aggressive over time. For
example, our staff recently encountered
many limited partnership agreements
that state that the adviser to the private
fund or its related person, which is the
general partner to the fund, to the
maximum extent permitted by
applicable law, will not be subject to
any duties or standards (including
fiduciary or similar duties or standards)
existing under the Advisers Act,
Delaware law, or Cayman Islands law or
will not be liable to the fund or
investors for breaching its duties
(including fiduciary duties) or liabilities
(that exist at law or in equity).170
While these contractual terms may be
permissible under certain state laws, a
waiver of an adviser’s compliance with
its Federal antifraud liability for breach
of fiduciary duty to the private fund or
with any other provision of the Advisers
170 See, e.g., EXAMS Private Funds Risk Alert
2022, supra footnote 16 (discussing hedge clauses).
See also Comment Letter of the Institutional
Limited Partners Association on the Proposed
Commission Interpretation Regarding Standard of
Conduct for Investment Advisers; Request for
Comment on Enhancing Investment Adviser
Regulation (Aug. 6, 2018), File No. S7–09–18, at 6,
available athttps://ilpa.org/wp-content/uploads/
2018/08/ILPA-Comment-Letter-on-SEC-ProposedFiduciary-Duty-Interpretation-August-6-2018.pdf.
See also Protecting LLC Owners While Preserving
LLC Flexibility, University of California, Davis Law
Review, 51 U.C. Davis L. Rev. 2129, 2133, Professor
Peter Molk (2018) (discussing scenarios in which an
investor is induced to ‘‘sign away fundamental
protections’’ without understanding the importance
of those protections, without understanding the
meaning of certain legal terms, and sometimes
without reading the documents the investor signs).
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Act or rules thereunder is invalid under
the Act.171 The prohibited activities rule
would specify the types of contractual
provisions that would be invalid.172 For
instance, it would prohibit an adviser
from seeking indemnification for
breaching its fiduciary duty, regardless
of whether state or other law would
permit an adviser to waive its fiduciary
duty. The proposed rule would also
prohibit an adviser from seeking
reimbursement for its willful
malfeasance. This scope of prohibitions
is appropriate because these activities
harm investors by placing the adviser’s
interests above those of its private fund
clients (and investors in such clients).
By limiting an adviser’s responsibility
for breaching the standard of conduct,
the incentive to comply with the
required standard of conduct is eroded.
We believe such contractual provisions
are neither in the public interest nor
consistent with the protection of
investors, particularly where investors
are led to believe the adviser is
contractually not obligated to comply
with certain provisions of the Act or
rules thereunder, or where investors
with less bargaining power are forced to
bear the brunt of such arrangements.173
We request comment on this aspect of
the proposed rule, including the
following items:
• We have observed these types of
contractual provisions among private
171 See section 215(a) of the Advisers Act; 2019
IA Fiduciary Duty Interpretation, supra footnote
140 (stating that an adviser’s Federal fiduciary
obligations are enforceable through section 206 of
the Advisers Act and that the SEC would view a
waiver of enforcement of section 206 as implicating
section 215(a) of the Advisers Act. Section 215(a)
of the Advisers Act provides that any condition,
stipulation or provision binding any person to
waive compliance with any provision of the title
shall be void.).
172 See section 215(b) of the Advisers Act (stating
that any contract made in violation of the Act or
rules thereunder is void).
173 See Professor Clayton Article, supra footnote
7, at 309 (noting that ‘‘LPAs have been criticized for
waiving and otherwise limiting managers’ fiduciary
duties to their investors under state limited
partnership law; for seeking to satisfy managers’
fiduciary duties under Federal law by providing
generic and all-encompassing disclosures . . . for
requiring investors to indemnify managers for
liabilities resulting from an extremely broad array
of conduct, including criminal acts committed by
managers’’). See also The Private Equity Negotiation
Myth, Yale Journal on Regulation Vol. 37:67,
Professor William Clayton (2020), at p. 70 (noting
that ‘‘large investors in private equity funds
commonly use their bargaining power to negotiate
for individualized benefits outside of fund
agreements, where the benefit of the bargain is not
shared with other investors in the fund . . . an
investor can use its bargaining power to negotiate
for individualized benefits before it negotiates for
things that will benefit all investors in the fund.’’);
ILPA Model Limited Partnership Agreement (July
2020) (suggesting standard of care, exculpation, and
indemnification language in order to reduce the
cost, time and complexity of negotiating the terms
of investment).
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fund advisers and their related persons;
do advisers to clients other than private
funds typically include these types of
contractual provisions?
• Are there other types of contractual
provisions we should prohibit as
contrary to the public interest and the
protection of investors?
• Should this aspect of the final
prohibited activities rule prohibit
limiting liability for ‘‘gross negligence,’’
or would prohibiting limitations of
liability for ordinary negligence, as
proposed, be more appropriate? Why?
• Should the proposed rule prohibit
contractual provisions that limit or
purport to waive fiduciary duties and
other liabilities in situations where state
law permits such waivers?
• Do commenters believe that the
proposed rule would increase operating
expenses for advisers? For example,
would the proposed prohibition on
receiving indemnification/exculpation
for negligence cause an adviser’s
insurance premium to increase?
5. Certain Non-Pro Rata Fee and
Expense Allocations
The sixth element of the prohibited
activities rule would prohibit an adviser
from directly or indirectly charging or
allocating fees and expenses related to
a portfolio investment (or potential
portfolio investment) on a non-pro rata
basis when multiple private funds and
other clients advised by the adviser or
its related persons have invested (or
propose to invest) in the same portfolio
investment.174
An adviser may cause a private fund
and one or more other vehicles to invest
in an issuer or entity in which other
related funds or vehicles have, or are
concurrently making, an investment.
For example, an adviser may form a
parallel fund in a non-U.S. jurisdiction,
such as Luxembourg, to accommodate
certain European or other non-U.S.
investors that invests alongside the
adviser’s main fund in all, or
substantially all, of its investments. An
adviser also may form more bespoke
structures for large or strategic investors,
such as separate accounts, funds of one,
and co-investment vehicles, that invest
alongside other funds managed by the
adviser that have similar or overlapping
investment strategies.
An adviser can face conflicts of
interest where multiple clients (and/or
other persons advised by the adviser)
invest, or propose to invest, in the same
portfolio investment, especially with
respect to allocating fees and expenses
among those clients (or such other
174 Proposed
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persons).175 We believe that any nonpro rata allocation of fees and expenses
under these circumstances is contrary to
the protection of investors because it
would result in the adviser placing its
own interest ahead of another’s,
including in circumstances where the
adviser indirectly benefits by placing
the interests of one or more clients or
investors ahead of another’s.176 For
example, a fund may not have the
resources to bear its pro rata share of
expenses related to a portfolio
investment (whether due to insufficient
reserves, the inability to call capital to
cover such expenses, or otherwise). If
the adviser causes another fund to bear
expenses attributable to such fund, the
fund bearing more than a pro rata share
would be supporting the value of the
other fund’s investment.177 Because
compensation structures in the funds
may differ, an adviser may have an
incentive to allocate fees and expenses
in a way that maximizes its
compensation. Further, an adviser’s
ownership may vary fund by fund and
thus may create an incentive to allocate
fees and expenses away from the fund
in which the adviser holds a greater
interest.178
Moreover, we do not believe that fees
and expenses attributable to
unconsummated—or potential—
portfolio investments should be treated
differently than consummated
investments, given that non-pro rata
allocations in respect of
175 See EXAMS Private Funds Risk Alert 2020,
supra footnote 9. See also, e.g., In the Matter of
Rialto Capital Management, LLC, Investment
Advisers Act Release No. 5558 (Aug. 7, 2020)
(settled action) (alleging that adviser represented to
the advisory committee, which included private
fund investors as committee members, that it had
data to support the adviser performing third-party
services in house and charging the funds certain
rates; and that the adviser misallocated fees for
third-party services to the private funds when such
fees also should have been allocated to the coinvestment vehicles managed by the adviser).
176 Because the proposed rule prohibits charging
or allocating fees and expenses related to a portfolio
investment (or potential portfolio investment) on a
non-pro rata basis, advisers would not be prohibited
from charging vehicles that invest alongside each
other different advisory fees or other fund-level
compensation. For example, a co-investment
vehicle may pay lower management fees than the
main fund.
177 The proposed rule would not prohibit an
adviser from paying a fund’s pro rata portion of any
fee or expense with its own capital. In addition, to
the extent a fund does not have resources to pay
for its share, the proposed rule would not prohibit
an adviser from diluting such fund’s interest in the
portfolio investment in a manner that is
economically equal to its pro rata portion of such
fee or expense.
178 On a more granular level, to the extent the
adviser’s personnel have varying ownership
percentages in the funds, such personnel may be
subject to similar conflicts of interest in
determining how to allocate fees and expenses.
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unconsummated investments generally
present the same concerns as discussed
above with respect to consummated
investments. If more than one fund
would have participated in an
investment that generated ‘‘broken deal’’
or other fees and expenses, our view is
that all such funds should bear their pro
rata share of such amount.
We recognize that many advisers do
not charge all their clients or potential
co-investors for fees and expenses
relating to unconsummated
investments. For example, certain
advisers offer existing investors, related
persons, or third parties the opportunity
to co-invest alongside the fund through
one or more co-investment vehicles
advised by the adviser.179 Many
advisers do not charge co-investment
vehicles or other co-investors for fees
and expenses relating to
unconsummated investments. Instead,
such fees and expenses are generally
borne by the adviser’s main fund that
would have participated in the
transaction, in which case the main
fund would bear a disproportionate
share of such amount. Such practice,
however, places the interests of the
other client and its underlying investors
or of the other co-investors ahead of the
interests of the main fund and its
underlying investors. 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.
Accordingly, the proposed rule does not
include an exception for these types of
circumstances.180
We request comment on this aspect of
the proposed prohibited activities rule,
including the following items:
• Should we prohibit non-pro rata fee
and expense allocations as proposed? If
179 In some cases, advisers use co-investment
opportunities to attract new investors and retain
existing investors. Advisers may offer these existing
or prospective investors the opportunity to invest
in co-investment vehicles with materially different
fee and expense terms than the main fund (e.g., no
fees or no obligation to bear broken deal expenses).
These co-investment opportunities may raise
conflicts of interest, particularly when the
opportunity to invest arises because of an existing
investment and the fund itself would otherwise be
the sole investor.
180 To the extent a potential co-investor has not
executed a binding agreement to participate in the
transaction through a co-investment vehicle (or
another fund) managed by the adviser, the proposed
rule would not prohibit the adviser from allocating
‘‘broken-deal’’ or other fees and expenses
attributable to such potential co-investor to a fund
that would have participated in the transaction.
Advisers may be liable under the antifraud
provisions of the Federal securities laws if the
private fund’s offering and organizational
documents do not authorize such costs to be
charged to the private fund.
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not, under what circumstances would
non-pro rata allocations be appropriate?
For example, we recognize that advisers
often have policies and procedures in
place that permit the adviser to allocate
fees and expenses in a fair and equitable
manner (or similar standard), rather
than on a pro rata basis; would this
better achieve our policy goals? Why or
why not? What specific protections are
included in such policies and
procedures? Should such protections be
included in the rule? Why or why not?
Should there be an exception to the
prohibition where an adviser
determines that it is in a private fund’s
best interest to bear more expenses than
another managed vehicle and the
private fund’s investors agree?
• Should the proposed rule apply to
unconsummated—or potential—
portfolio investments, as proposed? Do
commenters agree that non-pro rata
allocations of fees and expenses
attributable to such investments present
the same concerns as the ones discussed
above with respect to consummated
investments? Why or why not?
• We recognize that many coinvestors do not agree to bear their pro
rata share of broken or dead deal
expenses. Would the proposed rule
make it difficult for funds to
consummate larger investments where
co-investment capital is needed? Would
the proposed rule cause funds to
syndicate more deals post-closing once
the adviser is confident that the deal
will not fall through?
• Should we include an exception for
co-investment vehicles (or certain other
vehicles) that invest alongside another
fund managed by the adviser? If so, how
should we define ‘‘co-investment
vehicle’’? Should the rule treat singledeal co-investment vehicles differently
than multi-deal co-investment vehicles?
Why or why not?
• Should we define ‘‘pro rata’’?
Should ‘‘pro rata’’ be determined based
on each client’s ownership (or
anticipated ownership) of the portfolio
investment? Will advisers interpret ‘‘pro
rata’’ differently?
• Where multiple funds invest in the
same portfolio investment at different
times, the first fund to invest may
initially bear a higher level of fees and
expenses than later funds. Should the
proposed rule address fees and expense
allocations among funds that invest at
different times, and if so, how? If a
significant amount of time has passed
between the first fund’s investment and
the later fund’s investment, should the
later fund pay interest on its portion of
fees and expenses? Should interest
payments always apply when portfolio
investments are made at different times?
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If not, how much time should lapse
before interest applies?
• The proposed rule would prohibit
advisers from charging or allocating fees
and expenses related to a portfolio
investment (or potential portfolio
investment) on a non-pro rata basis
when multiple private funds and other
clients advised by the adviser or its
related persons have invested (or
propose to invest) in the same portfolio
investment. Is the scope of the phrase
‘‘other clients advised by the adviser or
its related persons’’ broad enough?
Should we revise the proposed rule to
cover any other clients, vehicles, or
other persons advised by the adviser or
its related persons? Alternatively,
should we revise the rule to cover all coinvestment structures and
arrangements?
• We recognize that a transaction
counterparty may request to only
contract with one fund entity, which
can result in one fund being liable for
its own share as well as another fund’s
share of any transaction obligations,
including fees and expenses. If one fund
would be responsible for the liability of
another fund, those funds, in certain
cases, contractually agree to bear their
pro rata share, often times through a
contribution or reimbursement
agreement. Should we prohibit this
practice and thus require each fund
entity to contract directly with the
counterparty? Alternatively, should we
require certain governance and other
protections, such as contribution or
reimbursement agreements, if only one
fund contracts directly with the
counterparty? Why or why not?
• As noted above, the proposed rule
would not prohibit an adviser from
charging different fund-level
compensation, such as advisory fees, to
vehicles that invest alongside each other
in the same underlying portfolio
investment. For example, a coinvestment vehicle may pay lower
management fees than the main fund. Is
it sufficiently clear that such
arrangements would not be prohibited
under the proposed rule?
6. Borrowing
The final element of the proposed
prohibited activities rule would prohibit
an adviser directly or indirectly from
borrowing money, securities, or other
fund assets, or receiving a loan or an
extension of credit, from a private fund
client (collectively, a ‘‘borrowing’’).181
We have observed many forms of
borrowing among private fund advisers
and their related persons, such as using
fund assets as collateral in order to
181 Proposed
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obtain a loan from a party other than the
fund (i.e., borrowing against fund
assets), accepting a loan offered by a
private fund client, and taking
advantage of a continuous line of credit
extended by a private fund client. For
example, the Commission has brought
enforcement actions alleging that
private fund advisers and their related
persons have used fund assets to
address personal financial issues of one
of the adviser’s principals, to pay for the
advisory firm’s expenses,182 or to bribe
foreign government officials.183 In these
circumstances, the adviser’s related
person that is the general partner of the
fund sometimes, for example, causes the
fund to enter into the relationship with
the adviser without the knowledge or
consent of the private fund investors.
When an adviser borrows from a
private fund client, that adviser has a
conflict of interest because it is on both
sides of the transaction (i.e., the adviser
benefits from the loan and manages the
client lender). A private fund rarely has
employees of its own. Its officers, if any,
are usually employed by the private
fund’s adviser. The fund typically relies
on the investment adviser (and, in
certain cases, affiliated entities) to
provide management, investment, and
other services and such persons usually
have authority to take actions on behalf
of the private fund without the consent
or approval of any other person. This
structure causes a conflict of interest
between the private fund (and, by
extension, its investors) and the
investment adviser because the interests
of the fund are not necessarily aligned
with the interests of the adviser. For
example, when determining the interest
rate for the borrowing, an investment
adviser’s interest in maximizing its own
profit by negotiating (or setting) a low
rate may conflict with its duty to act in
the best interests of the fund.
182 See In the Matter of Monsoon Capital, LLC,
Investment Advisers Act Release No. 5490 (Apr. 30,
2020) (settled action) (alleging that the owner of a
private fund adviser borrowed $1 million from a
private fund client in order to settle a personal
trade); Resilience Management, LLC, Investment
Advisers Act Release No. 4721 (June 29, 2017)
(settled action) (alleging that a private fund adviser
borrowed money from funds in order to pay
adviser’s expenses; and that the CEO of the adviser
borrowed money to pay for personal expenses); SEC
v. Philip A. Falcone, [U.S. District Court Southern
District of New York, Consent] (Aug. 16, 2013)
(hedge fund adviser borrowed from hedge fund at
low interest rate in order to repay adviser’s personal
taxes. Adviser failed to disclose the loan to
investors for five months).
183 See In the Matter of Och-Ziff Capital
Management Group, LLC, Investment Advisers Act
Release No. 4540 (Sept. 29, 2016), at para. 3 (settled
action) (alleging that a private fund adviser
authorized the use of investor funds to pay bribes
to foreign government officials in order to obtain or
retain business for its parent company and its
business partners).
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Moreover, this practice may prevent
the fund client from using those assets
to further the fund’s investment
strategy. Even where 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 private 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.
The proposed rule would not prevent
the adviser from borrowing from a third
party on the fund’s behalf or from
lending to the fund. Private funds
sometimes use subscription lines of
credit, also known as credit facilities, to
address financing needs. For example,
some private funds use these facilities to
address short-term financing needs
when the fund makes investments or
participates in a co-investment. Other
private funds use such facilities for
long-term financing purposes, for
example, when an infrastructure fund
decides to use a long-term facility
during the development stage of a
project before a capital call. In these
circumstances, the adviser is not
borrowing from the fund. Similarly,
advisers sometimes lend money to a
fund in order to address start-up costs
or to manage other expenses (for
example, an adviser may pay legal or
operating expenses of several fund
clients and then seek reimbursement
once the expenses have been allocated
among the advised private funds).
Allowing advisers to continue this
practice would provide private funds
access to capital, especially when they
are in the early stages of attracting
investors. Advisers lending to private
funds they manage on terms that do not
include excessive interest rates or other
abusive practices do not raise the same
concerns that advisers borrowing from
private funds they manage raises
because there are fewer opportunities
for abusive practices when the adviser
is providing money to, rather than
taking money from, the private fund.
We request comment on this aspect of
the proposed prohibitions rule,
including the following:
• Should we broaden the scope of the
prohibition on borrowings to prevent a
private fund adviser from borrowing
from co-investment vehicles or other
accounts that are not private funds?
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• Should we broaden the proposed
prohibition to apply when an adviser
lends to the fund? 184
• Should the proposed rule exclude
certain activity from the prohibition
(e.g., scenarios where a private fund
makes tax advances or tax distributions
to its general partner (or similar control
person) to ensure that the general
partner and its investment professionals
are able to pay their personal taxes
derived from the general partner’s
interest in the fund)? If so, what activity
should we exclude and why?
• Are there situations in which a fund
would agree to lend a start-up adviser
money for initial costs and employee
salaries? Are there situations in which
a private fund client should be able to
make a loan to a private fund adviser
because the economic terms would be
favorable to the private fund? How
would we determine that the terms are
favorable to the private fund?
• Should the proposed rule be
expanded to prohibit an adviser from
borrowing against a private fund client’s
bank account or other assets, where the
lender may be a third party (rather than
the private fund)? Why or why not?
• Should we amend Form ADV and/
or Form PF to require advisers to report
information about an adviser or its
related person lending to, or borrowing
from, private funds or other clients?
Why or why not? For example, should
we require advisers to report whether
they engage in this practice and to
provide an aggregate amount or range of
such loans or borrowings?
• Recognizing the limitations of
private fund governance mechanisms, as
discussed above, should we permit
borrowing if it is subject to specific
governance and other protections (e.g.,
advance disclosure to all investors,
advance disclosure to an LPAC or
similar body, consent of a governing
body such as an LPAC, and/or consent
of a majority or supermajority of
investors)? Should we require private
fund advisers to make ongoing
disclosures to investors and/or
governing bodies of the status of such
borrowings? Why or why not?
• Should the rule include any full or
partial exclusions for certain
transactions that may not involve
conflicts of interest or that may involve
certain third parties that ameliorate the
conflicts of interest? For example,
should we provide an exclusion if the
184 See,
e.g., In the Matter of Clean Energy Capital
LLC, Investment Advisers Act Release No. 3955
(Oct. 17, 2014) (settled action) (alleging that a
private equity fund adviser caused the funds to
borrow money from the adviser without providing
notice to investors and by pledging the private
equity funds’ assets as collateral).
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terms of the borrowing are set by an
independent third party and such third
party has the authority to act on behalf
of the fund in the event of a default by
the adviser? Why or why not?
• Do commenters envision
unintended consequences of this
proposed prohibition, such as in
circumstances where an adviser’s
related person has its own commercial
relationship with the fund?
• Should the rule prohibit (or
otherwise restrict) advisers from lending
to private funds they manage on terms
that include excessive interest rates or
other abusive practices? To what extent
and under what circumstances does this
practice occur? Does it raise similar
concerns to borrowing?
E. Preferential Treatment
In order to address specific types of
preferential treatment that have a
material negative effect on other
investors in the private fund or in a
substantially similar pool of assets, we
also propose to prohibit all private fund
advisers, regardless of whether they are
registered with the Commission, from
providing preferential terms to certain
investors regarding redemption or
information about portfolio holdings or
exposures.185 We also propose to
prohibit these advisers from providing
any other preferential treatment to any
investor in the private fund unless the
adviser provides written disclosures to
prospective and current investors in a
private fund regarding all preferential
treatment the adviser or its related
persons are providing to other investors
in the same fund.186 Whether any terms
are ‘‘preferential’’ would depend on the
facts and circumstances.
Side letters or side arrangements are
generally agreements among the
investor, general partner, adviser, and/
or the private fund that provide the
investor with different or preferential
terms than those set forth in the fund’s
governing documents.187 Side letters
generally grant more favorable rights
and privileges to certain preferred
investors (e.g., seed investors, strategic
investors, those with large
185 Proposed
rule 211(h)(2)–3(a)(1) and (2).
rule 211(h)(2)–3(b).
187 The proposed rule would prohibit certain
types of preferential treatment and would require
an adviser to disclose other types of preferential
treatment that the adviser or its related persons
(acting on their own behalf and/or on behalf of the
fund) provide to investors. Therefore, the proposed
rule typically would apply when the adviser’s
related person is the general partner (or similar
control person) and is a party (and/or caused the
private fund to be a party, directly or indirectly) to
a side letter or other arrangement with an investor,
even if the adviser itself (or any related person of
the adviser) is not a party to the side letter or other
arrangement.
186 Proposed
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commitments, and employees, friends,
and family) or to investors subject to
government regulation (e.g., the
Employee Retirement Income Security
Act (‘‘ERISA’’), the Bank Holding
Company Act, or public records laws).
Advisers often provide these terms for
strategic reasons that benefit the adviser.
In some cases, these terms can also
benefit the fund, for example, if the
adviser signs a side letter with a large,
early stage investor, then the fund will
increase its assets. Increased fund assets
may enable the fund to make certain
investments, for example of a larger
size, which ultimately benefits all
investors. However, preferential terms
do not necessarily benefit the fund or
other investors that are not party to the
side letter agreement and, at times, we
believe these terms can have a material,
negative effect on other investors.
We recognize that advisers provide a
range of preferential treatment, some of
which does not necessarily
disadvantage other fund investors. In
this case, we believe that disclosure is
appropriate because it would allow
investors to make their own assessment.
Other types of preferential treatment,
however, have a material, negative effect
on other fund investors or investors in
a substantially similar pool of assets. We
propose to prohibit these types of
preferential treatment because they are
sales practices that present a conflict of
interest between the adviser and the
private fund client that are contrary to
the public interest and protection of
investors. We have tailored the
proposed rule to address these different
ends of the spectrum.
Prohibited Preferential Redemptions
We propose to prohibit a private fund
adviser, including indirectly through its
related persons, from granting an
investor in the private fund or in a
substantially similar pool of assets the
ability to redeem its interest 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.188
Different types of private funds and
other pooled vehicles offer different
redemption opportunities, and an
investor’s ability to exit or withdraw
differs significantly depending on the
fund’s or pool’s liquidity profile. While
open-end private funds typically allow
188 Proposed rule 211(h)(2)–3(a)(1). For purposes
of the prohibitions in proposed rule 211(h)(2)–
3(a)(1) or (2), whether an adviser could have a
reasonable expectation that the preferential term
would have a material, negative effect on other
investors in the same private fund or in a
substantially similar pool of assets would depend
on the facts and circumstances.
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for periodic redemptions, closed-end
private funds typically do not permit
investors to withdraw their investments
without consent. We understand that
some private fund advisers grant one or
more investors more favorable
redemption rights. For example, a large
investor may negotiate, through a side
letter or other side arrangement, to be
able to redeem its interest in the fund
before, or more frequently than, other
investors. Advisers enter into such
arrangements in exchange for, for
example, a large investor agreeing to
invest in the fund or a large investor
agreeing to participate in a future
fundraising of an investment vehicle
that the adviser manages.189 Our staff
also has observed scenarios where an
adviser establishes investment vehicles
that invest side-by-side along with the
private fund that have better liquidity
terms than the terms provided to
investors in the private fund.190
We believe that granting preferential
liquidity terms on terms that the adviser
reasonably expects to have a material,
negative effect on other investors in the
private fund or in a substantially similar
pool of assets is a sales practice that is
harmful to the fund and its investors. In
granting preferential liquidity rights to a
large investor, the adviser stands to
benefit because its fees increase as fund
assets under management increase. As
noted above, the adviser attracts
preferred investors to invest in the fund
by offering preferential terms, such as
more favorable liquidity rights. While
the fund also may experience some
benefits, including the ability to attract
additional investors and to spread
expenses over a broader investor and
asset base, there are scenarios where the
preferential liquidity terms harm the
fund and other investors. For example,
if an adviser allows a preferred investor
to exit the fund early and sells liquid
assets to accommodate the preferred
investor’s redemption, the fund may be
left with a less liquid pool of assets,
which can inhibit the fund’s ability to
carry out its investment strategy or
promptly satisfy other investors’
redemption requests. This can dilute
remaining investors’ interests in the
fund and make it difficult for those
investors to mitigate their investment
losses in a down market cycle. These
concerns can also apply when an
adviser provides favorable redemption
rights to an investor in a substantially
similar pool of assets, such as another
feeder fund investing in the same master
189 See supra section II.E. (Preferential Treatment)
(discussing side letters as a sales practice).
190 See EXAMS Private Funds Risk Alert 2020,
supra footnote 9.
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fund. The Commission believes that the
potential harms to other investors justify
this restriction.
Prohibited Preferential Transparency
We propose to prohibit an adviser and
its related persons from providing
information regarding the portfolio
holdings or exposures of the private
fund or of a substantially 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 substantially similar
pool of assets.191
Private fund advisers, in some cases,
disclose information about portfolio
holdings or exposures to certain, but not
all, investors in the private fund or in
a substantially similar pool of assets.
For example, an investor may request
certain information about characteristics
of the fund’s holdings to satisfy the
investor’s internal reporting obligations.
An investor can negotiate to receive
certain types of information that is not
widely available to all investors;
however, an investor’s success in
obtaining such terms may depend on
factors including the size of its capital
commitment.192
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.
Granting preferential transparency, for
example through side letters, presents a
sales practice that is contrary to the
public interest and protection of
investors because it preferences one
investor at the expense of another. An
adviser may agree to provide
preferential information rights to a
certain investor in exchange for
something of benefit to the adviser. The
proposed rule is designed to neutralize
the potential for private fund advisers to
treat portfolio holdings information as a
commodity to be used to gain or
maintain favor with particular
investors.193 We believe that this
191 Proposed
rule 211(h)(2)–3(a)(2).
Professor Clayton Article, supra footnote
7, at 316 (noting that large investors can often
negotiate fee discounts or other side letter benefits
that smaller investors would not receive).
193 See Selective Disclosure and Insider Trading,
Securities Act of 1933 Release No. 33–7881 (Aug.
15, 2000) [65 FR 51715 (Aug. 24, 2000)].
192 See
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proposed prohibition would curtail
activity that harms investors.
Substantially Similar Pool of Assets
The proposed rule would define the
term ‘‘substantially similar pool of
assets’’ as a pooled investment vehicle
(other than an investment company
registered under the Investment
Company Act of 1940 or a company that
elects to be regulated as such) with
substantially similar investment
policies, objectives, or strategies to those
of the private fund managed by the
adviser or its related persons.194
Whether a pool of assets managed by the
adviser is ‘‘substantially similar’’ to the
private fund requires a facts and
circumstances analysis. A pool of assets
with a materially different target return
or sector focus, for example, would
likely not have substantially similar
investment policies, objectives, or
strategies as the subject private fund,
depending on the facts and
circumstances.
The types of asset pools that would be
included in this term would include a
variety of pools, regardless of whether
they are private funds. For example, this
term would include limited liability
companies, partnerships, and other
organizational structures, regardless of
the number of investors; feeders to the
same master fund; and parallel fund
structures and alternative investment
vehicles. It would also include pooled
vehicles with different base currencies
and pooled vehicles with embedded
leverage to the extent such pooled
vehicles have substantially similar
investment policies, objectives, or
strategies as those of the subject private
fund. In addition, an adviser would be
required to consider whether its
proprietary accounts meet the definition
of ‘‘substantially similar pool of assets.’’
This proposed definition is designed
to capture most commonly used fund
structures and prevent advisers from
structuring around the prohibitions on
preferential treatment. For example, in a
master-feeder structure, some advisers
create custom feeder funds for favored
investors. Without a comprehensive
definition of substantially similar pool
of assets, the proposed rule would not
preclude such advisers from providing
preferential treatment to investors in
these custom feeder funds to the
detriment of investors in standard
commingled feeder funds within the
master-feeder structure. While similar
concerns may exist for separately
managed accounts, this proposed rule is
designed to address the specific
concerns that arise out of the lack of
194 Proposed
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transparency and governance
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Other Preferential Treatment
The proposed rule also would
prohibit other preferential terms unless
the adviser provides certain written
disclosures to prospective and current
investors.195 We believe that certain
types of preferential terms raise
relatively minor concerns, if fully
disclosed. However, we are concerned
that an adviser’s current sales practices
do not provide all investors with
sufficient detail regarding preferential
terms granted to other investors.196 For
example, an adviser to a private equity
fund may provide ‘‘excuse rights’’ (i.e.,
the right to refrain from participating in
a specific investment the private fund
plans to make) to certain private fund
investors. Advisers sometimes grant
excuse rights to accommodate an
investor’s unique investment
restrictions, such as a mandate to avoid
investment in portfolio companies that
do not meet certain environmental,
social, or governance standards. This
lack of transparency prevents investors
from understanding the scope of
preferential terms granted. The
proposed rule would prohibit these
terms unless the adviser provides
information about them in a written
notice.
Increased transparency would better
inform investors regarding the breadth
of preferential treatment, the potential
for those terms to affect their investment
in the private fund, and the potential
costs (including compliance costs)
associated with these preferential
terms.197 This disclosure would help
investors shape the terms of their
relationship with the adviser of the
private fund. For example, they might
also learn of similarly situated investors
who are receiving a better deal with
respect to fees or other terms. An
investor also may learn that the adviser
provided fee discounts to a large, early
stage investor. Or, an investor may learn
that the adviser granted a strategic
investor the right to increase its
investment in the fund even though the
fund is closed to new investors or to
additional investments by other existing
195 Proposed
rule 211(h)(2)–3(b).
Juliane Begenau and Emil Siriwardane,
How Do Private Equity Fees Vary Across Public
Pensions?, Harvard Business School (2020),
available at https://www.hbs.edu/faculty/Pages/
item.aspx?num=57534.
197 The Alternative Investment Fund Managers
Directive (AIFMD) includes transparency
obligations requiring disclosure to all investors of
any preferential treatment received by a particular
investor, including by way of a side letter. See
AIFMD Art. 23.
196 See
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investors. This may lead the investor to
request additional information on other
benefits that the adviser’s related
persons or large investors receive, such
as co-investment rights. An investor
may then be able to understand better
certain potential conflicts of interest and
the risk of potential harms or other
disadvantages.
Under the proposed rule, 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),
in order to provide specific information
as required by the proposed rule. An
adviser could comply with the proposed
disclosure requirements by providing
copies of side letters (with identifying
information regarding the other
investors redacted).198 Alternatively, an
adviser could provide a written
summary of the preferential terms
provided to other investors in the same
private fund, provided the summary
specifically describes the preferential
treatment.
The timing of the proposed rule’s
delivery requirements would differ
depending on whether the recipient is a
prospective or existing investor in the
private fund. For a prospective investor
the notice needs to be provided, in
writing, prior to the investor’s
investment. For an existing investor, the
adviser would have to ‘‘distribute’’ the
notice annually if any preferential
treatment is provided to an investor
since the last notice.199 An adviser
would satisfy its distribution
requirement to current investors by
sending the written notice to all of the
private fund’s investors. If an investor is
a pooled investment vehicle that is in a
control relationship with the adviser,
the adviser must look through that pool
in order to send the notice to investors
198 We are not proposing to require the adviser to
disclose the names or even types of investors
provided preferential terms as part of this proposed
disclosure requirement.
199 As a practical matter, a private fund that does
not admit new investors or provide new terms to
existing investors would not need to deliver an
annual notice. However, an adviser that enters into
a side letter after the closing date of the fund would
need to disclose any covered preferential terms in
the side letter to investors that are locked into the
fund.
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in those pools.200 We believe this aspect
of the proposed rule would require
advisers to reassess periodically the
preferential terms they provide to
investors in the same fund, and
investors would benefit from receiving
periodic updates on preferential terms
provided to other investors in the same
fund. We also believe that providing
this information annually would not
overwhelm investors with disclosure.
We request comment on this aspect of
the proposed rule, including the
following:
• Should the proposed rule apply
only to SEC-registered advisers and
advisers that are required to be
registered with the SEC instead of all
advisers, as proposed?
• Should we prohibit all preferential
treatment instead of the proposed
approach, which is to prohibit certain
types of preferential treatment (i.e.,
liquidity and transparency terms that an
adviser reasonably expects to have a
material, negative effect) and prohibit
all other types of preferential treatment
unless disclosed? Why or why not?
• Should the proposed prohibitions
apply only to terms that the adviser
reasonably expects to have a material,
negative effect, as proposed?
Alternatively, should the proposed
prohibitions apply more broadly to
terms that the adviser reasonably
expects could have a material, negative
effect? Why or why not?
• Should we prohibit all preferential
liquidity terms, rather than just those
that the adviser reasonably expects to
have a material, negative effect on other
investors in that fund or in a
substantially similar pool of assets?
Why or why not?
• Are there certain investors who
require different liquidity terms (e.g.,
ERISA plans, government plans)? If so,
which types of investors and what
liquidity terms do they require? How do
advisers currently accommodate such
investors without disadvantaging other
investors in the private fund? Should
the proposed rule permit different
liquidity terms for these investor types?
If so, should the proposed rule impose
restrictions in order to protect other
private fund investors? If so, which
types of restrictions?
• Are there practices related to
liquidity and redemption rights that the
proposed rule should explicitly address
(e.g., in-kind distribution of securities in
connection with a redemption, sidepocketing of illiquid investments,
discounting or eliminating the
management fee while a fund suspends
200 See supra section II.A.3 (Preparation and
Distribution of Quarterly Statements).
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liquidity)? For example, should the
proposed rule prohibit in-kind
distribution of securities in connection
with a redemption, side-pocketing
illiquid investments, or discounting or
eliminating the management fee while a
fund suspends liquidity? Alternatively,
should the proposed rule include an
exception for these activities?
• Should we prohibit all preferential
transparency regarding holdings or
exposures of the fund or pool, rather
than just prohibiting preferential
transparency regarding holdings or
exposures that the adviser reasonably
expects to have a material, negative
effect on other investors in that fund or
in a substantially similar pool of assets?
Why or why not?
• Should we define, or provide
guidance on, when preferential
redemption terms or preferential
information rights would have a
material, negative effect on other
investors? If so, what should be some
determining factors? Would it be
relevant that the redemption terms
would cause another investor to
reconsider its investment decision?
Please explain your answer. Should we
clarify whether an adviser could
disclose information about holdings or
exposures of the fund or a substantially
similar pool of assets on a delayed basis
without violating the proposed
prohibition? Should the proposed rule
expressly require disclosure to investors
after a specified period? If so, what
period?
• Are transparency concerns,
especially with regard to information
that could have an impact on an
investor’s decision to redeem, more
prominent with certain fund types (e.g.,
hedge funds, private equity funds)? If
so, which types and why?
• Should we exempt certain types of
private funds from the written notice
requirements of the proposed
preferential treatment rule? 201 If so,
which types of funds and why?
• Should we restrict the use of side
letters and side arrangements so that
they can only be used to address certain
matters such as, for example, legal,
regulatory, or tax issues that are specific
to an investor?
• Should the rule’s prohibitions on
preferential terms extend to a
substantially similar pool of assets or
apply only to each private fund
separately?
• The proposed definition of
‘‘substantially similar pool of assets’’
would not include co-investments by a
separately managed account managed
by the adviser or its related persons. Is
201 See
proposed rule 211(h)(2)–3(b).
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this definition too narrow? Why or why
not? Would the proposed definition
appropriately capture similar funds?
Should it, for example, include
circumstances where a private fund
invests alongside a separately managed
account? Why or why not? Should the
definition include a co-investment
vehicle that is structured as a pool of
assets that invests in a single entity and
where the private fund invests in the
same entity?
• Should we limit ‘‘substantially
similar pool of assets’’ to pools the
adviser or its related persons manage, as
proposed? Is the proposed definition too
broad or too narrow? The proposed
definition would require the pool of
assets to have substantially similar (i)
investment policies, (ii) objectives, or
(iii) strategies to those of the private
fund. Should we change ‘‘or’’ to ‘‘and’’
and instead require that the pool satisfy
all three requirements (i.e., have
substantially similar investment
policies, objectives, and strategies)?
Should we instead require that the pool
satisfy only two of the three criteria? For
example, should the definition only
require the pool of assets to have
substantially similar objectives and
strategies (and not policies) to those of
the private fund? Are there other unique
characteristics or factors, such as the
target rate of return, the proposed
definition should address? Should the
definition exclude multi-share class
private funds? If so, why?
• Should we narrow the scope of the
term ‘‘substantially similar pool of
assets’’ to only include pooled vehicles
that invest or generally invest pari passu
with the private fund? Why or why not?
• Do commenters agree that we
should prohibit other preferential terms
unless the adviser provides specific
information regarding those terms to
prospective and current private fund
investors? Would these disclosures
benefit these investors? Should we
require advisers to provide additional
information in the written notices? If so,
what information? Should the rule
specify what information is required to
be included in the notice?
• Instead of requiring advisers to
provide or distribute the written notice,
should we require advisers to only
provide or distribute the written notice
upon request?
• With regard to current investors, the
proposed rule would require advisers to
disclose preferential treatment provided
by the adviser or its related persons.
Instead or in addition, should we
require advisers to disclose preferential
treatment that it has offered to other
investors in the same fund?
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• Should we require advisers to
provide advance written notice to
prospective investors, as proposed?
Should we define ‘‘prospective
investor’’ in the proposed rule? If so,
how should we define this term and
why? For example, should we define
‘‘prospective investor’’ as any person or
entity that has expressed an interest in
a private fund advised by the
adviser? 202 If not, should we provide
guidance regarding how advisers can
identify prospective investors? Should
we clarify how advisers that use
intermediaries, investment consultants,
or other third parties to introduce
prospective investors would comply
with the proposed rule? For example,
should we state that advisers must treat
the intermediaries, investment
consultants, or other third parties as the
prospective investor in these
circumstances? Should the definition
include prospective transferees? Why or
why not?
• The proposed rule would require
the adviser to provide the written notice
‘‘prior to the investor’s investment in
the private fund.’’ Should we prescribe
how far in advance of the investment an
adviser must provide such notice? For
example, should we require an adviser
to provide the written notice at least two
business days prior to the date of
investment? Should such period be
longer or shorter? If so, why? Should the
proposed rule require advisers to
provide notice to prospective investors
within a certain number of days before
the investor submits its complete
subscription agreement (or equivalent)?
Alternatively, should the proposed rule
require the adviser to provide the notice
at the time an investor receives the
private fund’s offering and
organizational documents (e.g., limited
partnership agreement, private
placement memorandum)? Should we
instead require that notice be sent prior
to some other action or event? If so,
what action or event and why? Should
the proposed rule require advisers to
update disclosure they previously
provided, for example, to include
preferential treatment that an adviser
granted after some investors decided to
invest, but before closing?
• What impact would the advance
written notice requirement have on
‘‘most favored nation’’ clauses (‘‘MFN
clauses’’) granted to other fund
investors? 203
202 See CFA Institute Global Investment
Performance Standards for Firms: Glossary, CFA
Institute (2020) (defining ‘‘prospective investor’’).
203 In an MFN clause, an adviser or its related
person generally agrees to provide an investor with
contractual rights or benefits that are equal to or
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• Should the rule require disclosure
of all preferential treatment, as
proposed, or should the rule have a
narrower or broader scope?
• Should the proposed rule require
the adviser to disclose how it
memorialized the preferential treatment
(e.g., formal written side letter, email)?
• The proposed rule would require
the adviser to provide written notice.
Should the proposed rule instead allow
advisers to disclose this information
orally and keep a record evidencing
such oral disclosure? Why or why not?
• The proposed rule would require
the adviser to provide notice on an
annual basis to current investors, if the
adviser or its related persons provided
any preferential treatment to other
investors in the same private fund since
the last written notice. The proposed
rule does not specify whether the
adviser must provide this on a calendar
year basis, the adviser’s fiscal year, or
on a rolling annual basis. Should the
rule specify precisely when the annual
period begins and ends? Why or why
not? If so, what should the beginning
and ending dates be? Instead of an
annual notice, should we require an
adviser to provide the notice within 30
days of providing any new preferential
treatment to an investor in the fund?
• Should we require an adviser to
document the years during which it has
not provided any preferential treatment
and therefore need not distribute or
provide a written notice to current
investors or prospects, respectively?
Why or why not? If an adviser has not
provided preferential treatment to any
investors, or has not done so during the
applicable time period, should we
require an adviser to send current
investors and prospects a written notice
confirming that it does not have any
preferential treatment to disclose? Why
or why not?
• The proposed rule would require
advisers to provide or distribute a
written notice that provides ‘‘specific’’
information about preferential
treatment. Should the proposed rule
define ‘‘specific’’ or use another term to
describe the required level of detail?
1. Recordkeeping for Preferential
Treatment
We propose amending rule 204–2
under the Advisers Act to require
advisers registered with the Commission
to retain books and records to support
their compliance with the proposed
preferential treatment rule.204 In
connection with the written notices
better than the rights or benefits provided to certain
other investors.
204 Proposed rule 211(h)(2)–3(b).
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required by proposed rule 211(h)(2)–3,
advisers would be required to retain
copies of all written notices sent to
current and prospective investors in a
private fund pursuant to that rule.205 In
addition, advisers would be required to
retain copies of a record of each
addressee and the corresponding dates
sent, addresses, and delivery method for
each addressee. These proposed
requirements would facilitate our staff’s
ability to assess an adviser’s compliance
with the proposed rule and would
similarly enhance an adviser’s
compliance efforts.
We request comment on this aspect of
the proposed rule:
• Would the proposed recordkeeping
requirement be overly burdensome for
advisers? Why or why not?
• Would advisers face more difficulty
retaining records regarding prospective
investors as compared to retaining
records for current investors? Would it
be more difficult for advisers to keep
track of prospective investors? For
example, prospective investors may
express interest in a private fund, but
may not actually invest. Should we only
require advisers to retain records
regarding prospective investors that
invest in the private fund?
• The books and records rule under
the Advisers Act applies to SECregistered advisers. Should we adopt a
recordkeeping obligation that would
require other advisers (such as exempt
reporting advisers) to retain the written
notices that proposed rule 211(h)(2)–3
would require? Why or why not?
III. Discussion of Proposed Written
Documentation of all Advisers’ Annual
Reviews of Compliance Programs
We are proposing to amend the
Advisers Act compliance rule to require
all SEC-registered advisers to document
the annual review of their compliance
policies and procedures in writing.206
We believe that such a requirement
would focus renewed attention on the
importance of the annual compliance
review process. In addition, we believe
that the proposed amendment would
result in records of annual compliance
reviews that would allow our staff to
determine whether an adviser has
complied with the review requirement
of the compliance rule.207
205 See supra footnote 106 (describing the record
retention requirements under the books and records
rule). See also proposed amendments to rule 204–
2(a)(7)(v).
206 Proposed rule 206(4)–7(b).
207 See Compliance Programs of Investment
Companies and Investment Advisers, Investment
Advisers Act Release No. 2204 (Dec. 17, 2003) [38
FR 74714 (Dec. 24, 2003)] (‘‘Compliance Rule
Adopting Release’’). When adopting the compliance
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The compliance rule currently
requires advisers to review, no less
frequently than annually, the adequacy
of their compliance policies and
procedures and the effectiveness of their
implementation. The annual review
requirement was intended to require
advisers to evaluate periodically
whether their compliance policies and
procedures continue to work as
designed and whether changes are
needed to assure their continued
effectiveness.208 As we stated in the
Compliance Rule Adopting Release,
‘‘the annual review should consider any
compliance matters that arose during
the previous year, any changes in the
business activities of the adviser or its
affiliates, and any changes in the
Advisers Act or applicable regulations
that might suggest a need to revise the
policies and procedures.’’
Based on staff experience, some
investment advisers do not make and
preserve written documentation of the
annual review of their compliance
policies and procedures. The
compliance rule does not expressly
require written documentation.209 Our
examination staff relies on
documentation of the annual review to
help the staff understand an adviser’s
compliance program, determine
whether the adviser is complying with
the rule, and identify potential
weaknesses in the compliance program.
Without documentation that the adviser
rule, the Commission adopted amendments to the
books and records rule requiring advisers to make
and keep true a copy of the adviser’s compliance
policies and procedures and any records
documenting an adviser’s annual review of its
compliance policies and procedures. The
Commission noted that this recordkeeping
requirement was designed to allow our examination
staff to determine whether the adviser has complied
with the compliance rule. See also rule 204–
2(a)(17)(i)–(ii).
208 See Compliance Programs of Investment
Companies and Investment Advisers, Investment
Advisers Act Release No. 2107 (Feb. 5, 2003) [68
FR 7038 (Feb. 11, 2003)] (‘‘Compliance Rule
Proposing Release’’).
209 The Commission has identified instances
where it alleged no annual review of the
compliance program was conducted. See, e.g., In re
du Pasquier & Co., Inc., Investment Advisers Act
Release No. 4004 (Jan. 21, 2015) (settled action)
(alleging that the adviser failed to annually review
the adequacy of its compliance policies and
procedures and the effectiveness of their
implementation); In re Pekin Singer Strauss Asset
Management Inc., et al., Investment Advisers Act
Release No. 4126 (June 23, 2015) (settled action)
(alleging that the adviser failed to complete timely
annual compliance program reviews); In the Matter
of Hudson Hous. Capital, LLC, Investment Advisers
Act Release No. 5047 (Sept. 25, 2018) (settled
action) (alleging that the adviser failed to review its
policies and procedures at least annually); In the
Matter of ED Capital Management, LLC, Investment
Advisers Act Release No. 5344 (Sept. 13, 2019)
(settled action) (alleging that the adviser failed to
conduct the required annual reviews of its written
policies and procedures).
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conducted the review, including
information about the substance of the
review, our staff has limited visibility
into the adviser’s compliance practices.
The proposed amendment to rule
206(4)–7 would establish a written
documentation requirement applicable
to all advisers.210
Proposed rule 206(4)–7(b) does not
enumerate specific elements that
advisers must include in the written
documentation of their annual review.
The written documentation requirement
is intended to be flexible to allow
advisers to continue to use the review
procedures they have developed and
found most effective. For example, some
advisers may review the adequacy of
their compliance policies and
procedures (or a subset of those
compliance policies and procedures)
and the effectiveness of their
implementation on a quarterly basis. In
such a case, we believe that the written
documentation of the annual review
could comprise written quarterly
reports.
The regulations in 17 CFR 270.38a–1
(rule 38a–1 under the Investment
Company Act), the compliance rule
applicable to registered investment
companies and business development
companies (collectively ‘‘registered
funds’’), do not require written
documentation of a registered fund’s
annual review of its compliance policies
and procedures.211 However, rule 38a–
1 requires a registered fund’s CCO to
provide a written report to the registered
fund’s board of directors, at least
annually, that addresses: (i) The
operation of the compliance policies
and procedures of the registered fund
and each investment adviser, principal
underwriter, administrator, and transfer
agent of the registered fund; (ii) any
material changes made to those policies
and procedures since the date of the last
report; (iii) any material changes to the
policies and procedures recommended
210 The adviser would be required to maintain the
written documentation of its annual review in an
easily accessible place for at least five years after
the end of the fiscal year in which the review was
conducted, the first two years in an appropriate
office of the investment adviser. See rule 204–
2(a)(17)(ii) and (e)(1).
211 While business development companies (as
defined in the Investment Company Act) are
exempt from the registration provisions of that Act,
we include them within the term ‘‘registered funds’’
for ease of reference. See 15 U.S.C. 80a–2(a)(48); 15
U.S.C. 80a–6(f). Rule 38a–1(a)(3) under the
Investment Company Act requires a registered fund
to review, no less frequently than annually, the
adequacy of the policies and procedures of the
registered fund and of each investment adviser,
principal underwriter, administrator, and transfer
agent and the effectiveness of their implementation.
Rule 38a–1(d) under the Investment Company Act
requires a registered fund to maintain any records
documenting the fund’s annual review.
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as a result of the registered fund’s
annual review of its policies and
procedures; and (iv) each material
compliance matter that occurred since
the date of the last report.212 With
registered funds, written accountability
has been helpful to ensure compliance
with the Federal securities laws, and the
proposed requirements for investment
advisers are intended to provide similar
benefits.213 The proposed required
written documentation of the annual
review under the compliance rule is
meant to be made available to the
Commission and the Commission staff
and, therefore, should promptly be
produced upon request.214 Commission
staff has observed claims of the
attorney-client privilege, the workproduct doctrine, or other similar
protections over required records,
including any records documenting the
annual review under the compliance
rule, based on reliance on attorneys
working for the adviser in-house or the
engagement of law firms and other
service providers (e.g., compliance
consultants) through law firms.215
Attempts to shield from, or
unnecessarily delay production of any
non-privileged record is inconsistent
with prompt production obligations and
undermines Commission staff’s ability
to conduct examinations. Prompt access
to all records is critical for protecting
investors and to an effective and
efficient examination program.
We request comment on the proposed
amendments to the compliance rule:
• Should we expressly require
advisers to document the annual review
212 Rule 38a–1(a)(4)(iii) under the Investment
Company Act. For purposes of rule 38a–1, a
‘‘material compliance matter’’ is defined as any
compliance matter about which the registered
fund’s board of directors would reasonably need to
know to oversee fund compliance, including
violations of the Federal securities laws by the
registered fund. See rule 38a–1(e)(2) under the
Investment Company Act.
213 Our staff has observed that registered funds
also generally retain these reports with their board
meeting minutes, which aids our staff’s ability to
assess compliance with rule 38a–1. See rule 31a–
1(b)(4) under the Investment Company Act
(requiring registered investment companies to
maintain and keep current certain books, accounts,
and other documents, including minute books of
directors’ or trustees’ meetings; and minute books
of directors’ or trustees’ committee and advisory
board or advisory committee meetings).
214 In connection with the written report required
under rule 38a–1, the Compliance Rule Adopting
Release stated that ‘‘[a]ll reports required by our
rules are meant to be made available to the
Commission and the Commission staff and, thus,
they are not subject to the attorney-client privilege,
the work-product doctrine, or other similar
protections.’’ See Compliance Rule Adopting
Release, supra footnote 207, at n.94.
215 Staff also has observed delays in production
of other non-privileged records. Delays undermine
the staff’s ability to conduct examinations, and may
be inconsistent with production obligations.
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16933
of their compliance policies and
procedures in writing, as proposed? If
not, why?
• Should we specify certain elements
that must be included in the written
documentation of the annual review?
For example, should we require the
written documentation to address
matters similar to those that are required
in the chief compliance officer’s written
report to a registered fund’s board of
directors pursuant to rule 38a–1 under
the Investment Company Act? Despite
the limitations of private fund
governance mechanisms, as discussed
above, should we require the new
documentation to be provided to
LPACs, directors, or other governing
bodies of private funds? Why or why
not?
• Are there alternate means to
document an adviser’s annual review of
its compliance program?
• Are there exceptions to the written
documentation requirement that we
should adopt?
IV. Transition Period and Compliance
Date
We are proposing a one-year
transition period to provide time for
advisers to come into compliance with
these new and amended rules if they are
adopted. Accordingly, we propose that
the compliance date of any adoption of
this proposal would be one year
following the rules’ effective dates,
which would be sixty days after the date
of publication of the rules in the Federal
Register.
Staff in the Division of Investment
Management is reviewing staff
statements, including staff no-action
letters and staff interpretative letters, to
determine whether any statements, or
portions thereof, should be withdrawn
or modified in connection with any
adoption of this proposal. Upon the
adoption of any rule, some letters and
other staff statements, or portions
thereof, may be moot, superseded, or
otherwise inconsistent with the rule
and, therefore, would be withdrawn or
modified. If interested parties believe
that certain letters or other staff
statements, or portions thereof, should
be withdrawn or modified, they should
identify the letter or statement, state
why it is relevant to the proposed rule,
how it or any specific portion thereof
should be treated, and the reason
therefor. Interested parties also should
explain any concerns with the
withdrawal or modification of any staff
statements and letters on this topic.
We request comments on the
proposed transition period:
• Do commenters agree that a oneyear transition period following each
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rule’s effective date if adopted is
appropriate? Should the period be
shorter or longer? For example, would
six months be an appropriate amount of
time? Alternatively, would eighteen
months be necessary?
• Should the transition period be the
same for all of the proposed new and
amended rules if adopted? Should we
have different compliances dates for
each proposed rule? Why or why not,
and for which rules?
• Should the transition period be the
same for all advisers subject to the
proposed rules, if adopted?
Alternatively, should we adopt a tiered
transition period for smaller or larger
entities? For example, should we
provide an additional six months in the
transition period for smaller entities (or
some other shorter or longer period)?
How should we define smaller entities
for this purpose?
• Should advisers to certain fund
types have a longer (or shorter)
transition period? Would compliance
with some or all of the proposed rules
be more complex for advisers to certain
fund types, such as private equity,
venture capital, real estate or other
similar closed-end private funds, than
for advisers to other fund types, such as
hedge funds or other similar open-end
private funds?
• The proposed quarterly statement
rule would require advisers to report
performance since the fund’s inception.
Should we allow funds that existed
before the compliance date of the
proposed rule to include performance
information only for periods beginning
on or after the proposed rule’s
compliance date? Should the proposed
rule include a maximum period of time
that funds that are in existence as of the
compliance date must look back in
order to report performance, fees, and
expenses? Is it common practice for
older funds (e.g., hedge fund incepted
30 years ago) to retain records to
support that performance? Would it be
burdensome for advisers to provide
since-inception performance
information?
V. Economic Analysis
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A. Introduction
We are mindful of the costs imposed
by, and the benefits obtained from, our
rules. Whenever we engage in
rulemaking and are required to consider
or determine whether an action is
necessary or appropriate in the public
interest, section 202(c) of the Advisers
Act requires the Commission to
consider, in addition to the protection of
investors, whether the action would
promote efficiency, competition, and
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capital formation. The following
analysis considers, in detail, the
potential economic effects that may
result from this rulemaking, including
the benefits and costs to market
participants as well as the broader
implications of the proposed rules for
efficiency, competition, and capital
formation.
Where possible, the Commission
quantifies the likely economic effects of
its proposed amendments and rules.
However, the Commission is unable to
quantify certain economic effects
because it lacks the information
necessary to provide estimates or ranges
of costs. Further, in some cases,
quantification would require numerous
assumptions to forecast how investment
advisers and other affected parties
would respond to the proposed
amendments and rules, and how those
responses would in turn affect the
broader markets in which they operate.
In addition, many factors determining
the economic effects of the proposed
amendments and rules would be firmspecific and thus inherently difficult to
quantify, such that, even if it were
possible to calculate a range of potential
quantitative estimates, that range would
be so wide as to not be informative
about the magnitude of the benefits or
costs associated with the proposed
rules. Many parts of the discussion
below are, therefore, qualitative in
nature. As described more fully below,
the Commission is providing a
qualitative assessment and, where
feasible, a quantified estimate of the
economic effects.
B. Economic Baseline
The economic baseline against which
we evaluate and measure the economic
effects of the proposed rules, including
its potential effects on efficiency,
competition, and capital formation, is
the state of the world in the absence of
the proposed rules. We consider the
current business practices and
disclosure practices of private fund
advisers, as well as the current
regulation and the forms of external
monitoring and investor protections that
are currently in place. In addition, in
considering the current business and
disclosure practices, we consider the
usefulness of the information that
investment advisers provide to investors
about the private funds in which those
investors invest, including information
that may be helpful for deciding
whether to invest (or remain invested)
in the fund, monitoring an investment
in the fund (in relation to fund
documents and in relation to other
funds), and other purposes. We further
consider the effectiveness of the
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disclosures in providing useful
information to the investor. For
example, fund disclosures can have
direct effects on investors by affecting
their ability to assess costs and returns
and to identify the funds that align with
their investment preferences and
objectives. Disclosures can also help
investors monitor their private fund
advisers’ conduct, depending in part on
the extent to which private funds lack
governance mechanisms that would
otherwise help check adviser conduct.
Disclosures can therefore influence the
matches between investor choices of
private funds and preferences over
private fund terms, investment
strategies, and investment outcomes,
with more effective disclosures resulting
in improved matches.
1. Industry Statistics and Affected
Parties
The proposed quarterly statement,
audit, and adviser-led secondary rules
would apply to all SEC registered
investment advisers (‘‘RIAs’’) with
private fund clients.216 Proposed
amendments to the books and records
rule would also impose corresponding
recordkeeping obligations on these
advisers.217 The proposed performance
requirements of the quarterly statement
rule would vary according to whether
the RIA determines the fund is a liquid
fund, such as a hedge fund, or an
illiquid fund, such as a private equity
fund.218 According to Form ADV data,
there are 5,139 such RIAs with private
fund clients.
The proposed prohibited activity and
preferential treatment rules would apply
to all advisers to private funds,
regardless of whether the advisers are
registered with or reporting as exempt
reporting advisers (‘‘ERAs’’) to the
Commission or one or more state
securities commissioners or are
otherwise not required to register.
Proposed amendments to the books and
records rule would also impose
corresponding recordkeeping
obligations on private fund advisers if
they are registered with the
Commission.219 Based on Form ADV
data, this would include approximately
216 See proposed rules 206(4)–10, 211(h)(1)–2,
211(h)(2)–2. As discussed above, the proposed rules
that pertain to registered investment advisers apply
to all investment advisers registered, or required to
be registered, with the Commission. See supra
section II.
217 See proposed rules 204–2(a)(20), (21), (22),
and (23).
218 See proposed rules 211(h)(1)–2(d).
219 See proposed rule 204–2(a)(7)(v) (imposing
recordkeeping requirements for notices required
under the proposed preferential treatment rule).
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Federal Register / Vol. 87, No. 57 / Thursday, March 24, 2022 / Proposed Rules
12,500 advisers to private funds, across
RIAs and ERAs.220
The proposed amendments to the
compliance rule would affect all RIAs,
regardless of whether they have private
fund clients. According to Form ADV
data, there are 15,283 RIAs, across both
those who do and do not have private
fund clients.
The parties affected by these various
proposed rules would include the
private fund advisers, advisers to other
client types (with respect to the
proposed amendments to the
compliance rule), private funds, private
fund investors, certain other pooled
investment vehicles and clients advised
by private fund advisers and their
related persons, and others to whom
those affected parties would turn for
assistance in responding to the
proposed rules. Private fund investors
are generally institutional investors
(including, for example, retirement
plans, trusts, endowments, sovereign
wealth funds, and insurance
companies), as well as high net worth
individuals. In addition, the parties
affected by these various proposed rules
could include private fund portfolio
investments, such as portfolio
companies. For example, certain types
of fees, such as accelerated payment
fees, would no longer be able to be
charged to those portfolio companies.
The relationships between the
affected parties are governed in part by
current rules under the Advisers Act, as
discussed in Section V.B.3. In addition,
relationships between funds and
investors generally depend on fund
governance.221 Private funds typically
lack fully independent governance
mechanisms, such as an independent
board of directors or LPAC with direct
access to fund information, that would
help monitor and govern private fund
adviser conduct and check possible
overreaching. Although some private
funds may have LPACs or boards of
directors, these types of bodies may not
have the necessary independence,
authority, or accountability to oversee
and consent to these conflicts or other
harmful practices as they may not have
sufficient access, information, or
authority to perform a broad oversight
role. Moreover, the interests of one or
more private fund investors may not
represent the interests of, or may
otherwise conflict with the interests of,
other investors in the private fund due
to business or personal relationships or
other private fund investments, among
other factors. To the extent investors are
afforded governance or similar rights,
such as LPAC representation, certain
fund agreements permit such investors
to exercise their rights in a manner that
places their interests ahead of the
private fund or the investors as a whole.
For example, certain fund agreements
state that, subject to applicable law,
LPAC members owe no duties to the
private fund or to any of the other
investors in the private fund and are not
obligated to act in the interests of the
private fund or the other investors as a
whole.222
Based on Form ADV filing data
between October 1, 2020, and
September 30, 2021, 5,139 RIAs and
4,900 ERAs reported that they are
advisers to private funds.223 Based on
Form ADV data, hedge funds and
private equity funds are the most
frequently reported private funds among
RIAs, followed by real estate and
venture capital funds, as shown. In
comparison to RIAs, ERAs have fewer
assets under management and are more
frequently venture capital (VC) funds,
followed by private equity funds and
hedge funds, with real estate funds more
uncommon.
PRIVATE FUNDS REPORTED
Registered investment advisers
Private
funds
Any private funds ....................................
Hedge funds .....................................
Private equity funds .........................
Real estate funds .............................
Venture capital funds .......................
Securitized asset funds ....................
Liquidity funds ..................................
Other private funds ..........................
Feeder funds
44,378
11,508
18,820
4,174
2,065
2,273
86
5,452
Exempt reporting advisers
Gross assets
(billions)
12,789
6,731
3,803
963
163
81
7
1,048
17,470.7
8,409.1
5,086.0
804.2
290.4
864.0
328.8
1,688.1
Private
funds
23,940
2,007
6,104
876
13,860
96
11
986
Feeder funds
2,606
1,318
645
187
285
........................
........................
171
Gross assets
(billions)
5,014.2
1,980.9
1,457.3
119.3
996.3
48.4
133.4
278.6
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* Source: Form ADV submissions filed between October 1st, 2020 and Sep 30th, 2021. Funds that are listed by both registered investment advisers and SEC-exempt reporting advisers are counted under both categories separately. Gross assets include uncalled capital commitments on
Form ADV.
220 See
infra footnote 416 (with accompanying
text).
221 See e.g., Lucian Bebchuk, Alma Cohen, and
Scott Hirst, The Agency Problems of Institutional
Investors, Journal of Economic Perspectives (2017).
See also John Morley, The Separation of Funds and
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Managers: A Theory of Investment Fund Structure
and Regulation, 123 Yale Law Journal 1231–1287
(2014); Paul G. Mahoney, Manager-Investor
Conflicts in Mutual Funds, 18 Journal of Economic
Perspectives 161–182 (2004).
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222 We observe that LPACs tend to be limited in
their ability to receive disclosures about, oversee, or
provide approval or consent for addition, private
funds also do not have comprehensive mechanisms
for such governance by fund investors.
223 Form ADV Item 5.F.2 and Item 12.A.
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Also based on Form ADV data, the
market for private fund investing has
grown dramatically over the past five
years. For example, the assets under
management of private equity funds
reported by RIAs on Form ADV during
this period grew from $2.6 trillion to
$5.1 trillion, or by 96 percent. The
assets under management of hedge
funds reported by RIAs grew from $6.1
trillion to $8.4 trillion, or by 38
percent.224 The assets under
management of all private funds
reported by RIAs grew by fifty-five
percent over the past five years from $11
trillion to over $17 trillion,225 while the
number of private funds reported by
RIAs grew by thirty-one percent from
Private funds reported by ERAs
Private funds reported by RIAs
.-Gross Assets (Trillions) -Number of Private Funds
50,000
$20
45,000
$18
~ 40,000
$14 ~
35,000
$12
E.
Ill
...
~ 25,000
$10
~ 20,000
$8
11s,ooo
$6
cu
tiIll
~
Ill
Ill
e
(,!)
$4
10,000
Gross Assets (Trillions) -Number of Private Funds
$6
6,000
C
cu
'lij 30,000
.ii!
i
11111111111!111
$16Ill
C
Lt
33.8 thousand to 44.4 thousand. The
assets under management of all private
funds reported by ERAs grew by one
hundred fifty percent over the past five
years from $2 trillion to over $5 trillion,
while the number of private funds
reported by ERAs grew by forty percent
from 3.5 thousand to 4.9 thousand, as
shown in the figure below.226
~5,000
iii
C
::,
C
u..
$4
,2l4,000
ra
.ii!
~3,000
.
_8
$3
z
!=.
f
Ill
0
E
::,
.g
-
2,000
~
$2
Ill
Ill
e
(,!)
1,000
$1
$2
0
$0
$0
2017
2018
2019
2020
2017
2021
2018
2019
2020
2021
Advisers have a fiduciary duty to
clients, including private fund clients,
that is comprised of a duty of care and
a duty of loyalty enforceable under the
antifraud provision of Section 206.227
The duty of care includes, among other
things: (i) The duty to provide advice
that is in the best interest of the client,
(ii) the duty to seek best execution of a
client’s transactions where the adviser
has the responsibility to select brokerdealers to execute client trades, and (iii)
the duty to provide advice and
monitoring over the course of the
relationship.228 The duty of loyalty
requires that an adviser not subordinate
its client’s interests to its own.229
Private fund advisers are also prohibited
from engaging in fraud under the
general antifraud and anti-manipulation
provisions of the Federal securities
laws, including Section 10(b) of the
Exchange Act (and rule 10b-5
thereunder) and Section 17(a) of the
Securities Act.
Private fund advisers are also subject
to rule 206(4)–8 under the Advisers Act,
which prohibits investment advisers to
pooled investment vehicles, which
include private funds, from (1) making
any untrue statement of a material fact
or omitting to state a material fact
necessary to make the statements made,
in the light of the circumstances under
which they were made, not misleading,
to any investor or prospective investor
in the pooled investment vehicle; or (2)
otherwise engaging in any act, practice,
or course of business that is fraudulent,
deceptive, or manipulative with respect
to any investor or prospective investor
in the pooled investment vehicle. There
are no particularized requirements,
however, that deal with many of the
revised requirements in this proposal.
For example, there is no regulation
requiring an adviser to disclose multiple
different measures of performance to its
investors, to refrain from borrowing
from a private fund client, to obtain a
fairness opinion from an independent
opinion provider when leading
secondary transactions, or to disclose
preferential treatment of certain
investors to other investors.
In the absence of more particularized
requirements, we have observed
business practices of private fund
advisers that enrich advisers without
providing any benefit of services to the
private fund and its underlying
investors or create incentives for an
adviser to place its own interests ahead
of the private fund’s interests. For
example, as discussed above, some
private fund advisers have entered into
arrangements with a fund’s portfolio
investments to provide services which
permit the adviser to accelerate the
unpaid portion of fees upon the
occurrence of certain triggering events,
even though the adviser will never
provide the contracted-for services.230
These fees enrich advisers without
providing the benefit of any services to
224 The number of private equity funds reported
by RIAs on Form ADV during this period grew from
12,819 to 18,820, or by 47 percent. The number of
hedge funds reported by RIAs grew from 11,114 to
11,508, or by 3.5 percent.
225 As of September 30, 2021. As noted above, the
assets under management of registered private fund
advisers has since continued to grow, exceeding
$18 trillion as of November 31, 2021. See supra
footnote 6.
226 See Form ADV data.
227 See 2019 IA Fiduciary Duty Interpretation, see
also supra footnote 140. Investment advisers also
have antifraud liability with respect to prospective
clients under section 206 of the Advisers Act,
which, among other aspects, applies to transactions,
practices, or courses of business which operate as
a fraud or deceit upon prospective clients.
228 Id.
229 Id.
230 See supra section II.D.1.
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2.
Sales Practices, Compensation Arrangements, and Other
Business Practices of Private Fund Advisers
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Federal Register / Vol. 87, No. 57 / Thursday, March 24, 2022 / Proposed Rules
the private fund and its underlying
investors.
We have also seen a trend in the
industry where certain advisers charge a
private fund for fees and expenses
incurred by the adviser in connection
with the establishment and ongoing
operations of its advisory business.231
We recognize, for example, that certain
private fund advisers, most notably for
hedge funds that utilize a ‘‘passthrough’’ expense model, employ an
arrangement where the private fund
pays for most, if not all, of the adviser’s
expenses, and that in exchange, the
adviser does not charge a management,
advisory, or similar fee (but does charge
an incentive or performance fee on net
returns of the private fund).232 Under
these or other similar circumstances in
which advisers charge private funds fees
associated with the adviser’s cost of
being an investment adviser, investor
returns are reduced by the amount of
the adviser’s overhead and operating
costs.
Some investors may not anticipate the
performance implications of these
disclosed costs, or may avoid
investments out of concern that such
costs may be present. For those
investors, this could lead to a mismatch
between investor choices of private
funds and their preferences over private
fund terms, investment strategies, and
investment outcomes, relative to what
would occur in the absence of such
unexpected or uncertain costs.
In addition, our staff has observed
instances in which advisers have
entered into agreements that reduce the
amount of clawbacks by taxes paid, or
deemed to be paid, by the adviser or its
owners,233 and instances in which
limited partnership agreements limit or
eliminate liability for adviser
misconduct.234 While these agreements
are negotiated between fund advisers
and investors, as discussed above
advisers often have discretion over the
timing of fund payments, and so may
have greater control over risks of
clawbacks than anticipated by
investors.235 As such, reducing the
amount of clawbacks by actual,
potential, or hypothetical taxes therefore
passes an unnecessary and avoidable
cost to investors. This cost denies
investors the restoration of distributions
or allocations to the fund that they
231 See
supra section II.D.2.
232 See, e.g., Eli Hoffmann, Welcome To Hedge
Funds’ Stunning Pass-Through Fees, Seeking Alpha
(Jan. 24, 2017), available at https://seekingalpha.
com/article/4038915-welcome-to-hedge-fundsstunning-pass-through-fees.
233 See supra section II.D.3.
234 See supra section II.D.4.
235 See supra section II.D.3.
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would have been entitled to receive in
the absence of an excess of performancebased compensation paid to the adviser
or a related person. These clawback
terms can therefore reduce the
alignment between the fund adviser’s
and investors’ interests. Lastly, the
elimination of liability for adviser
misconduct could reduce or eliminate
investor recoveries of losses in
connection with misconduct, which
could make such misconduct more
likely to occur.
We have also observed some cases
where private fund advisers have
directly or indirectly (including through
a related person) borrowed from private
fund clients.236 This practice carries a
risk of investor harm because the fund
client may be prevented from using
borrowed assets to further the fund’s
investment strategy, and so the fund
may fail to maximize the investor’s
returns. This risk is relatively higher for
those investors that are not able to
negotiate or directly discuss the terms of
the borrowing with the adviser, and for
those funds that do not have an
independent board of directors or LPAC
to review and consider such
transactions.237
The staff also has observed harm to
investors from disparate treatment of
investors in a fund. For example, our
staff has observed scenarios where an
adviser grants certain private fund
investors and/or investments in
substantially similar pools of assets with
better liquidity terms than other
investors.238 These preferential liquidity
terms can disadvantage other fund
investors or investors in a substantially
similar pool of assets if, for instance, the
preferred investor is able to exit the
private fund or pool of assets at a more
favorable time.239 Similarly, private
fund advisers, in some cases, disclose
information about a private fund’s
investments to certain, but not all,
investors in a private fund, which can
result in profits or avoidance of losses
among those who were privy to the
information beforehand at the expense
of those kept in the dark.240 Currently,
many investors need to engage in their
own research regarding what terms may
be obtained from advisers, as well as
whether other investors are likely to be
obtaining better terms than those they
are initially offered.
The staff also has observed harm to
investors when advisers lead multiple
private funds and other clients advised
236 See
supra section II.D.6.
237 Id.
238 See
supra section II.E.
239 Id.
by the adviser or its related persons to
invest in a portfolio investment.241 In
those instances, the staff observed
advisers allocating fees and expenses
among those clients on a non pro rata
basis, resulting in some fund clients
(and investors in those funds) being
charged relatively higher fees and
expenses than other clients.242 Advisers
may make these decisions in order to
avoid charging some portion of fees and
expenses to funds with insufficient
resources to bear its pro rata share of
expenses related to a portfolio
investment (whether due to insufficient
reserves, the inability to call capital to
cover such expenses, or otherwise) or
funds in which the adviser has greater
interests.
We understand that it can be difficult
for investors to have full transparency
into the scenarios described above
relating to conflicts of interest. For
example, the Commission has pursued
enforcement actions against private
fund advisers where the adviser failed
to inform investors about benefits that
the advisers obtained from accelerated
monitoring fees.243 Further, the
Commission also has pursued
enforcement actions against private
fund advisers in other circumstances in
which investors were not informed of
relevant conflicts of interest.244
While our staff has observed that
some advisers have begun to more fully
disclose sales practices, conflicts of
interests, and compensation schemes to
investors and the practices that are
associated with them, we believe that it
may be hard even for sophisticated
investors with full and fair disclosure,
to understand the future implications of
terms and practices related to these
practices at the time of investment and
during the investment. Further, some
investors may find it relatively difficult
to negotiate agreements that would fully
protect them from bearing unexpected
portions of fees and expenses or from
other decreases in the value of
investments associated with the abovedescribed practices. For example, some
forms of negotiation may occur through
repeat-dealing that may not be available
to some smaller private fund
investors.245 For any investors affected
241 See
supra section II.D.5.
242 Id.
243 See
supra footnote 10 (with accompanying
text).
244 Id.
245 A study of leveraged buyout transactions from
1990–2012 found that accelerated monitoring fees
had been charged in 28 percent of leveraged buyout
transactions, representing 15 percent of total fees
charged in those transactions. See Ludovic
Phalippou, Christian Rauch, and Marc Umber,
240 Id.
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by these issues, including potentially
sophisticated investors, there may be
mismatches between investor choices of
private funds and preferences over
private fund terms, investment
strategies, and investment outcomes,
relative to what would occur in the
absence of such unexpected or
uncertain costs.
Our staff has also observed that
investors are generally not provided
with detailed information about these
preferential terms.246 This lack of
transparency prevents investors from
understanding the scope or magnitude
of preferential terms granted, and as a
result, may prevent such investors from
requesting additional information on
these terms or other benefits that certain
investors, including the adviser’s related
persons or large investors, receive. In
this case, these investors may simply be
unaware of the types of contractual
terms that could be negotiated. To the
extent this lack of transparency affects
investor choices of where to allocate
their capital, it can result in mismatches
between investor choices of private
funds and their preferences over private
fund terms, investment strategies, and
investment outcomes.
3. Private Fund Adviser Fee, Expense,
and Performance Disclosure Practices
Current rules under the Advisers Act
do not require advisers to provide
quarterly statements detailing fees and
expenses (including fees and expenses
paid to the adviser and its related
persons by portfolio investments) to
private fund clients or to fund investors.
The custody rule does, however,
generally require advisers whose private
fund clients are not undergoing a
financial statement audit to have a
reasonable basis for believing that the
qualified custodians that maintain
private fund client assets provide
quarterly account statements to the
fund’s limited partners. Those account
statements may contain some of this
information, though in our experience
adviser fees and expenses typically are
not presented with the level of
specificity the proposed quarterly
statement rule would require. In
addition, Form ADV Part 2A (the
‘‘brochure’’) requires certain
information about an adviser’s fees and
compensation. For example, Part 2A,
Item 6 of Form ADV requires an adviser
to disclose in its brochure whether the
adviser accepts performance-based fees,
whether the adviser manages both
accounts that are charged a
Private Equity Portfolio Company Fees, 129 Journal
of Financial Economics, 559–585 (2018).
246 See supra section II.E.
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performance-based fee and accounts
that are charged another type of fee, and
any potential conflicts. Although the
brochure is not required to be delivered
to investors in a private fund, the
information on Form ADV is available
to the public, including private fund
investors, through the Commission’s
Investment Adviser Public Disclosure
(‘‘IAPD’’) website.247 We understand
that many prospective fund investors
obtain the brochure and other Form
ADV data through the IAPD public
website.
Similarly, there currently are no
requirements under current Advisers
Act rules for advisers to provide
investors with a quarterly statement
detailing private fund performance.
Although our recently adopted
marketing rule contains requirements
that pertain to displaying performance
information and providing information
about specific investments in adviser
advertisements, these requirements do
not compel the adviser to provide
performance information to all private
fund clients or investors. Rather, the
requirements apply when an adviser
chooses to include performance or
address specific investments within an
advertisement.248
Within this framework, advisers have
exercised discretion in responding to
the needs of private fund investors for
periodic statements regarding fees,
expenses, and performance or similar
information on their current
investments.249 Broadly, current
investors in a fund rely on this
information in determining whether to
invest in subsequent funds and
investment opportunities with the same
adviser, or to pursue alternative
investment opportunities. When fund
advisers raise multiple funds
sequentially, they often consider current
investors to also be prospective
investors in their subsequent funds, and
247 Advisers generally are required to update
disclosures on Form ADV on both an annual basis,
or when information in the brochure becomes
materially inaccurate. Additionally, although
advisers are not required to deliver the Form ADV
Part 2A brochure to private fund investors, many
private fund advisers choose to provide the
brochure to investors as a best practice.
248 While the marketing rule became effective as
of May 4, 2021, the Commission has set a
compliance date of November 4, 2022 (eighteen
months following the effective date) to give advisers
sufficient time to comply with the provisions of the
amended rules. As a result, while some advisers
may have begun to comply with the marketing rule,
some advisers may not currently be in compliance
with the marketing rule. As discussed above, the
marketing rule and its specific protections would
generally not apply in the context of a quarterly
statement. See supra footnote 62.
249 See supra section II.B.1 (regarding the role of
governance mechanisms in the relationship
between the fund and the investors).
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so may make disclosures to motivate
future capital commitments. This has
led to the development of diverse
approaches to the disclosure of fees,
expenses, and performance.250 A private
fund adviser may agree, contractually or
otherwise, to provide disclosures to a
fund investor, and on the details of
these disclosures, at the time of the
investment or subsequently. A private
fund adviser also may provide such
information in the absence of an
agreement. The format, scope and
reporting intervals of these disclosures
vary across advisers and private
funds.251 Some disclosures provide
limited information while others are
more detailed and complex. Investors
may, as a result, find it difficult to
assess and compare alternative fund
investments, which can make it harder
to allocate capital among competing
fund investments or among private
funds and other potential investments.
Limitations in required disclosures by
advisers may therefore result in
mismatches between investor choices of
private funds and their preferences over
private fund terms, investment
strategies, and investment outcomes.
While a variety of practices are used,
as the market for private fund investing
has grown, some patterns have emerged.
We understand that most private fund
advisers currently provide current
investors with quarterly reporting, and
many private fund advisers
contractually agree to provide fee,
expense, and performance reporting to
current investors.252 Further, advisers
typically provide information to existing
investors about private fund fees and
expenses in periodic financial
statements, schedules, and other reports
under the terms of the fund
documents.253
However, reports that are provided to
investors may report only aggregated
expenses, or may not provide detailed
information about the calculation and
implementation of any negotiated
rebates, credits, or offsets.254 Investors
may use the information that they
receive about their fund investments to
monitor the expenses and performance
250 See, e.g., William W Clayton, Public Investors,
Private Funds, and State Law, 72 Baylor Law
Review 294 (BYU Law Research Paper No. 20–13)
(July 2020), available at: https://ssrn.com/
abstract=3573773.
251 One observer of the variation in reporting
practices across funds has suggested the use of a
standardized template for this purpose. See, e.g.,
Reporting Template, The Institutional Limited
Partners Association, available at https://ilpa.org/
reporting-template/. ILPA is a trade group for
investors in private funds.
252 See supra section II.A.1, II.A.2.
253 Id.
254 See supra section II.A.
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from those investments. Their ability to
measure and assess the impact of fees
and expenses on their investment
returns depends on whether, and to
what extent, they are able to receive
detailed disclosures regarding those fees
and expense and regarding fund
performance. Some investors currently
do not receive such detailed disclosures,
and this reduces their ability to monitor
the performance of their existing fund
investment or to compare it with other
prospective investments.
In other cases, adviser reliance on
exemptions from specific regulatory
burdens for other regulators can lead
advisers to make certain quarterly
disclosures. For example, while we
believe that many advisers to hedge
funds subject to the jurisdiction of the
U.S. Commodity Futures Trading
Commission (‘‘CFTC’’) rely on an
exemption provided in CFTC Regulation
§ 4.13 from the requirement to register
with CFTC as a ‘‘commodity pool
operator,’’ some may rely on other CFTC
exemptions, exclusions or relief.
Specifically, we believe that some
advisers registered with the CFTC may
operate with respect to a fund in
reliance on CFTC Regulation § 4.7,
which provides certain disclosure,
recordkeeping and reporting relief and
to the extent that the adviser does so,
the adviser would be required to, no less
frequently than quarterly, prepare and
distribute to pool participants
statements that present, among other
things, the net asset value of the exempt
pool and the change in net asset value
from the end of the previous reporting
period.
In addition, information about
advisers’ fees and about expenses is
often included in advisers’ marketing
documents, or included in the fund
documents. Many advisers to private
equity funds and other funds that would
be determined to be illiquid funds
under the proposed rule provide
prospective investors with access to a
virtual data room for the fund,
containing the fund’s offering
documents (including categories of fees
and expenses that may be charged), as
well as the adviser’s brochure and other
ancillary items, such as case studies.255
255 To the extent that a private fund’s securities
are offered pursuant to 17 CFR 230.500 through
230.508 (Regulation D of the Securities Act) and
such offering is made to an investor who is not an
‘‘accredited investor’’ as defined therein, that
investor must be provided with disclosure
documents that generally contain the same type of
information required to be provided in offerings
under Regulation A of the Securities Act, as well
as certain financial statement information. See 17
CFR 230.502(b). However, private funds generally
do not offer interests in funds to non-accredited
investors.
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These advisers meet the contractual and
other needs of investors for updated
information by updating the documents
in the data room. Many advisers to
funds that would be considered liquid
funds under the proposed rule, such as
hedge funds, tend not to use data rooms.
They instead take the approach of
sending email or using other methods to
convey updated information to
investors. For instance, prior to closing
on a prospective investor’s investment,
some advisers send out pre-closing
email messages containing updated
versions of these and other documents.
While these data rooms and email
communications are therefore limited in
their use for disclosing ongoing fees and
expenses over the life of the fund,
prospective investors at the start of the
life of a fund, or at or before the time
of their investment, may use this
information in conducting due
diligence, in deciding whether to seek to
negotiate the terms of investment, and
ultimately in deciding whether to invest
in the adviser’s fund.
The adviser’s and related persons’
rights to compensation, which are set
forth in fund documents, vary across
fund types and advisers and can be
difficult to quantify at the time of the
initial investment. For example,
advisers of private equity funds
generally receive a management fee
(compensating the adviser for bearing
the costs relating to the operation of the
fund and its portfolio investment) and
performance-based compensation
(further incentivizing advisers to
maximize investor value).256
Performance-based compensation
arrangements in private equity funds
typically require that investors recoup
capital contributions plus a minimum
annual return (called the ‘‘hurdle rate’’
or ‘‘preferred return’’), but these
arrangements can vary according to the
waterfall arrangement used, meaning
that distribution entitlements between
the adviser (or its related persons) and
the private fund investors can depend
on whether the proceeds are distributed
on a whole-fund (known as Europeanstyle) basis or a deal-by-deal (known as
American-style) basis.257 In the wholefund (European) case, the fund typically
allocates all investment proceeds to the
investors until they recoup 100% of
their capital contributions attributable
to both realized and unrealized
256 See
supra section II.A.1.
e.g., David Snow, Private Equity: A Brief
Overview, PEI Media (2007), available at https://
www.law.du.edu/documents/registrar/adv-assign/
Yoost_PrivateEquity%20Seminar_
PEI%20Media’s%20Private%20Equity%20%20A%20Brief%20Overview_318.pdf. See also
supra footnote 166.
257 See,
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16939
investments plus their preferred return,
at which point fund advisers typically
begin to receive performance-based
compensation.258 In the deal-by-deal
(American) case (or modified versions
thereof), it is common for investment
proceeds from each portfolio investment
to be allocated 100% to investors until
investors recoup their capital
contributions attributable to that
specific investment, any losses from
other realized investments, and their
applicable preferred return, and then
fund advisers can begin to receive
performance-based compensation from
that investment.259 Under the deal-bydeal waterfall, advisers can potentially
receive performance-based
compensation earlier in the life of the
fund, as successful investments can
deliver advisers performance-based
compensation before investors have
recouped their entire capital
contributions to the fund.260
Management fee compensation figures
and performance-based compensation
figures are not widely disclosed or
reported,261 but the sizes of certain of
these fees have been estimated in
industry and academic literature. For
example, one study estimated that from
2006–2015, performance-based
compensation alone for private equity
funds averaged $23 billion per year.262
Private fund fees increase as assets
under management increase, and the
private fund industry has grown since
2015, and as a result private equity
management fees and performancebased compensation fees may together
258 Id.
259 Id.
260 Waterfalls (especially deal-by-deal waterfalls)
typically have clawback arrangements to ensure
that advisers do not retain carried interest unless
investors recoup their entire capital contributions
on the whole fund, plus a preferred return. The
result is that total distributions to investors and
advisers under the two waterfalls can be equal (but
may not always be), conditional on correct
implementation of clawback provisions. In that
case, the key difference in the two arrangements is
that deal-by-deal waterfalls result in fund advisers
potentially receiving their performance-based
compensation faster. However, some deal-by-deal
waterfalls may also require fund advisers to escrow
their performance-based compensation until
investors receive their total capital contributions to
the fund plus their preferred return on the total
capital contributions. These escrow policies can
help secure funds that may need to be available in
the event of a clawback. Id.
261 Ludovic Phalipoou, An Inconvenient Fact:
Private Equity Returns & The Billionaire Factory
University of Oxford, Said Business School,
(Working Paper), (June 10, 2020), available at
https://ssrn.com/abstract=3623820 or https://
dx.doi.org/10.2139/ssrn.3623820.
262 Id. See also Division of Investment
Management: Analytics Office, Private Funds
Statistics Report: Fourth Calendar Quarter 2015, at
5 (July 22, 2016), available at https://www.sec.gov/
divisions/investment/private-funds-statistics/
private-funds-statistics-2015-q4.pdf.
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currently total over $100 billion dollars
in fees per year.263 Private equity
represents $4.2 trillion of the $11.5
trillion dollars in net assets under
management by private funds,264 and so
total fees across the private fund
industry may be over $200 billion
dollars in fees per year.265
In addition, advisers or their related
persons may receive a monitoring fee for
consulting services targeted to a specific
asset or company in the fund
portfolio.266 Whether they ultimately
retain the monitoring fee depends, in
part, on whether the fund’s governing
documents require the adviser to offset
portfolio investment compensation
263 Private equity management fees are currently
estimated to typically be 1.76 percent and
performance-based compensation is currently
estimated to typically be 20.3 percent of private
equity fund profits. See, e.g., Ashley DeLuce and
Pete Keliuotis, How to Navigate Private Equite Fees
and Terms, Callan’s Research Cafe´ (October 7,
2020), available at https://www.callan.com/
uploads/2020/12/2841fa9a3ea9
dd4dddf6f4daefe1cec4/callan-institute-privateequity-fees-terms-study-webinar.pdf. Private equity
net assets under management as of the fourth
quarter of 2020 were approximately $4.2 trillion.
Division of Investment Management: Analytics
Office, Private Funds Statistics Report: Fourth
Calendar Quarter 2020 at 5 (August 4, 2021),
available at https://www.sec.gov/divisions/
investment/private-funds-statistics/private-fundsstatistics-2020-q4.pdf. Total fees may be estimated
by multiplying management fee percentages by net
assets under management, and by multiplying
performance-based compensation percentages by
net assets under management and again by an
estimate of private equity annual returns, which
may conservatively be assumed to be approximately
10 percent. See, e.g., Michael Cembalest, Food
Fight: An Update on Private Equity Performance vs.
Public Equity Markets, J.P. Morgan Asset and
Wealth Management (June 28, 2021), available at
https://privatebank.jpmorgan.com/content/dam/
jpm-wm-aem/global/pb/en/insights/eye-on-themarket/private-equity-food-fight.pdf.
264 See Division of Investment Management:
Analytics Office, Private Funds Statistics Report:
Fourth Calendar Quarter 2020 at 5 (August 4, 2021),
available at https://www.sec.gov/divisions/
investment/private-funds-statistics/private-fundsstatistics-2020-q4.pdf.
265 For example, hedge fund management fees are
currently estimated to typically be 1.4 percent per
year and performance-based compensation is
currently estimated to typically be 16.4 percent of
hedge fund profits, approximately consistent with
private equity fees. See, e.g. Leslie Picker, Two and
Twenty is Long Dead: Hedge Fund Fees Fall Further
Below Onetime Industry Standard, CNBC, available
at https://www.cnbc.com/2021/06/28/two-andtwenty-is-long-dead-hedge-fund-fees-fall-furtherbelow-one-time-industry-standard.html (citing HRF
Microstructure Hedge Fund Industry Report Year
End 2020). Hedge funds as of the fourth quarter of
2020 were represented another approximately $4.7
trillion in net assets under management. See
Division of Investment Management: Analytics
Office, Private Funds Statistics Report: Fourth
Calendar Quarter 2020 at 5 (August 4, 2021),
available at https://www.sec.gov/divisions/
investment/private-funds-statistics/private-fundsstatistics-2020-q4.pdf.
266 See e.g., Ludovic Phalippou, Christian Rauch,
and Marc Umber, Private Equity Portfolio Company
Fees, 129 (3) Journal of Financial Economics, 559–
585 (2018).
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against other revenue streams or
otherwise provide a rebate to the fund
(and so indirectly to the fund
investors).267 There can be substantial
variation in the fees private fund
advisers charge for similar services and
performances.268 Ultimately, the fund
(and indirectly the investors) bears the
costs relating to the operation of the
fund and its portfolio investments.269
Regarding performance disclosure,
advisers typically provide information
about fund performance to investors
through the account statements,
transaction reports, and other reports.
Some advisers, primarily private equity
fund advisers, also disclose information
about past performance of their funds in
the private placement memoranda that
they provide to prospective investors.
Many standardized industry methods
have emerged that private funds rely on
to report returns and performance.270
However, each of these standardized
industry methods has a variety of
benefits and drawbacks, including
differences in the information they are
able to capture and their susceptibility
to manipulation by fund advisers.
For private equity and other funds
that would be determined to be illiquid
under the proposed rules, standardized
industry methods for measuring
performance must contend with the
complexity of the timing of illiquid
investments. One approach that has
emerged for computing returns for
private equity and other fund that
would be determined to be illiquid
funds is the internal rate of return
(‘‘IRR’’).271 As discussed above, an
267 See supra section II.A.1. There may be certain
economic arrangements where only certain
investors to the fund receive credits from rebates.
268 See e.g., Juliane Begenau and Emil
Siriwardane, How Do Private Equity Fees Vary
Across Public Pensions?, 20–073 Harvard Business
School (Working Paper) (January 2020) (Revised
February 2021) (concluding that a sample of public
pension funds investing in a sample of private
equity funds would have received an average of an
additional $8.50 per $100 invested had they
received the best observed fees in the sample);
Tarun Ramadorai and Michael Streatfield, Money
for Nothing? Understanding Variation in Reported
Hedge Fund Fees, Paris December 2012 Finance
Meeting EUROFIDAI–AFFI Paper, (March 28, 2011)
(finding that a sample of hedge fund advisers,
management fees ranging from less than .5 percent
to over 2 percent and finding incentive fees ranging
from less than 5 percent to over 20 percent, with
no detectible difference in performance by funds
with different management fees and only modest
evidence of higher incentive fees yielding higher
returns), available at https://ssrn.com/
abstract=1798628 or https://dx.doi.org/10.2139/
ssrn.1798628.
269 See supra section II.A.1, II.D.1.
270 As discussed above, certain factors are
currently used for determining how certain types of
private funds should report performance under U.S.
GAAP. See supra footnote 71 (with accompanying
text).
271 See supra section II.A.2.b.
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important benefit of IRR that drives its
use is that IRR can reflect the timing of
cash flows more accurately than other
performance measures.272 All else
equal, a fund that delivers returns to its
investors faster will have a higher IRR.
However, current use of IRR to
measure returns has a number of
drawbacks, including an upward bias in
the IRR that comes from a fund’s use of
leverage, assumptions about the
reinvestment of proceeds, and a large
effect on measured IRR from cash flows
that occur early in the life of the pool.
For example, as discussed above, some
private equity funds borrow extensively
at the fund level.273 This can cause IRRs
to be biased upwards. Since IRRs are
based in part on the length of time
between the fund calling up investor
capital and the fund distributing profits,
private equity funds can delay capital
call-ups by first borrowing from fundlevel subscription facilities to finance
investments.274 This practice has been
used by private equity funds to
artificially boost reported IRRs, but
investors must pay the interest on the
debt used and so can potentially suffer
lower total returns.275
As for reinvestment assumptions, the
IRR as a performance measure assumes
that cash proceeds have been reinvested
at the IRR over the entire investment
period. For example, if a private equity
or other fund determined to be illiquid
reports a 50% IRR but has exited an
investment and made a distribution to
investors early in its life, the IRR
assumes that the investors were able to
reinvest their distribution again at a
50% annual return for the remainder of
the life of the fund.276
Although IRR remains one of the
leading standardized methods of
reporting returns at present, these and
other drawbacks make IRR difficult as a
singular return measure, especially for
investors who likely may not
understand the limitations of the IRR
metric, and the differences between IRR
and total return metrics used for public
equity or registered investment funds.
Several other measures have emerged
for measuring the performance of
272 Id.
273 Id.
274 Id.
275 See e.g., James F. Albertus & Matthew Denes,
Distorting Private Equity Performance: The Rise of
Fund Debt, Frank Hawkins Kenan Institute of
Private Enterprise Report (June 2019), available at
https://www.kenaninstitute.unc.edu/wp-content/
uploads/2019/07/DistortingPrivateEquity
Performance_07192019.pdf.
276 See e.g., Oliver Gottschalg and Ludovic
Phalippou, The Truth About Private Equity
Performance, Harvard Business Review (Dec. 2007),
available at https://hbr.org/2007/12/the-truthabout-private-equity-performance.
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private equity and other funds that
would be determined to be illiquid
under the proposal. These measures
compensate for some of the
shortcomings of IRR at the cost of their
own drawbacks. Multiple of invested
capital (MOIC), used by private equity
funds, is the sum of the net asset value
of the investment plus all the
distributions received divided by the
total amount paid in. MOIC is simple to
understand in that it is the ratio of value
received divided by money invested,
but has a key drawback that, unlike IRR,
MOIC does not take into account the
time value of money. Another measure,
Public Market Equivalent (‘‘PME’’), also
used by private equity and other funds
determined to be illiquid, is sometimes
used to compare the performance of a
fund with the performance of an
index.277 The measure is an estimate of
the value of fund cash flows relative to
the value of a public market index.
Relative to a given benchmark,
differences in PME can indicate
differences in the performance of
different private fund investments.
However, the computation of the PME
for a fund requires the availability of
information about fund cash flows
including their timing and magnitude.
Regardless of the performance
measure applied, another fundamental
difficulty in reporting the performance
of funds determined to be illiquid is
accounting for differences in realized
and unrealized gains. Funds determined
to be illiquid funds generally pursue
longer-term investments, and reporting
of performance before the fund’s exit
requires estimating the unrealized value
of ongoing investments.278 There are
often multiple methods that may be
used for valuing an unrealized illiquid
investment. As discussed above, the
valuations of these unrealized illiquid
investments are typically determined by
the adviser and, given the lack of readily
available market values, can be
challenging. Such methods may rely on
unobservable models and other
inputs.279 Because advisers are typically
evaluated (and, in certain cases,
compensated) based on the value of
these illiquid investments, unrealized
valuations are at risk of being inflated,
such that fund performance may be
277 See e.g., Robert Harris, Tim Jenkinson and
Steven Kaplan, Private Equity Performance: What
Do We Know?, 69 (5) Journal of Finance 1851 (Mar.
27, 2014), available at https://onlinelibrary.
wiley.com/doi/full/10.1111/jofi.12154; Steven
Kaplan and Antoinette Schoar, Private Equity
Performance: Returns, Persistence, and Capital
Flows, 60 (5) Journal of Finance (Aug. 2005),
available at https://web.mit.edu/aschoar/www/
KaplanSchoar2005.pdf.
278 See supra section II.A.2.b.
279 Id.
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overstated.280 Some academic studies
have found broadly that private equity
performance is overstated, driven in
part by inflated accounting of ongoing
investments.281
Other approaches tend to be used for
evaluating the performance of hedge
funds and other liquid funds. In
particular, a fund’s alpha is its excess
return over a benchmark index of
comparable risk. A fund’s Sharpe ratio
is its excess return above the risk-free
market rate divided by the investment’s
standard deviation of returns. Many, but
not all, hedge funds disclose these and
other performance measures, including
net returns of the fund. Many hedge
fund-level performance metrics can be
calculated by investors directly using
data on the fund’s historical returns, by
either combining with publicly
available benchmark index data (in the
case of alpha) or by combining with an
estimate of the standard deviation of the
fund’s returns (in the case of the Sharpe
ratio). Despite these detailed methods,
public data on hedge fund performance
reporting may also be biased, because
hedge funds choose whether and when
to make their performance results
publicly available.282
While the Commission believes that
many advisers currently select from
these varying standardized industry
methods in order to prepare and present
performance information, the difficulty
in measuring and reporting returns on a
basis comparable with respect to risk,
coupled with the potentially high fees
and expenses associated with these
funds, can present investors with
difficulty in monitoring and selecting
their investments. Specifically, without
disclosure of detailed performance
measures and accounting for the impact
of risk, debt, the varying impact of
realized and unrealized gains,
performances across funds can be highly
overstated or otherwise manipulated,
and so impossible to compare.283
280 Id.
281 See e.g., Ludovic Phalippou and Oliver
Gottschalg, The Performance of Private Equity
Funds, 22 (4) The Review of Financial Studies
1747–1776 (Apr. 2009).
282 See e.g., Philippe Jorion and Christopher
Schwarz, The Fix Is In: Properly Backing Out
Backfill Bias, 32 (12) The Society For Financial
Studies 5048–5099 (Dec. 2019); see also Nickolay
Gantchev, The Costs of Shareholder Activism:
Evidence From A Sequential Decision Model, 107
Journal of Financial Economics 610–631 (2013).
283 See, e.g., Ludovic Phalippou and Oliver
Gottschalg, The Performance of Private Equity
Funds, 22 (4) The Review of Financial Studies,
1747–1776 (Apr. 2009); Michael Cembalest, Food
Fight: An Update on Private Equity Performance vs.
Public Equity Markets, J.P. Morgan Asset and
Wealth Management (June 28, 2021), available at
https://privatebank.jpmorgan.co/content/dam/jpmwm-aem/global/pb/en/insights/eye-on-the-market/
private-equity-food-fight.pdf.
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4. Fund Audits and Fairness Opinions
Currently under the custody rule,
some private fund advisers may obtain
financial statement audits as an
alternative to the requirement of the rule
that an RIA with custody of client assets
obtain an annual surprise examination
from an independent public
accountant.284 This incentivizes
registered private fund advisers to have
the financial statements of their private
fund clients audited. Advisers of funds
that obtain these audits, regardless of
the type of fund, are thus able to
provide fund investors with reasonable
assurances of the accuracy and
completeness of the fund’s financial
statements and, specifically, that the
financial statements are free from
material misstatements.285
Also under the custody rule, an
adviser’s choice for a fund to obtain an
external financial statement audit (in
lieu of a surprise examination) may
depend on the benefit of the audit from
the adviser’s perspective, including the
benefit of any assurances that an audit
might provide investors about the
reliability of the financial statement.
The adviser’s choice also may depend
on the cost of the audit, including fees
and expenses.
Based on Form ADV data and as
shown below, more than 90 percent of
the total number of hedge funds and
private equity funds that are advised by
RIAs currently undergo a financial
statement audit, though such audits are
not necessarily always by a PCAOBregistered independent public
accountant that is subject to regular
inspection.286 Other types of funds
284 See supra section II.B; rule 206(4)–2(b)(4). The
staff has stated that, in order to meet the
requirements of rule 206(4)–2(b)(4), these financial
statements must be prepared in accordance with
U.S. GAAP or, for certain non-U.S. funds and nonU.S. advisers, prepared in accordance with other
standards, so long as they contain information
substantially similar to statements prepared in
accordance with U.S. GAAP, with material
differences reconciled. See Staff Responses to
Questions About the Custody Rule, available at
https://www.sec.gov/divisions/investment/custody_
faq_030510.htm.
285 See, e.g., AS 2301: The Auditor’s Responses to
the Risks of Material Misstatement, PCAOB,
available at https://pcaobus.org/oversight/
standards/auditing-standards/details/AS2301; AU–
C Section 240: Consideration of Fraud in a
Financial Statement Audit, AICPA (2021), available
at https://us.aicpa.org/content/dam/aicpa/
research/standards/auditattest/
downloadabledocuments/au-c-00240.pdf.
286 Rule 206(4)–2(a)(4) requires that an adviser
that is registered or required to be registered under
Section 203 of the Act with custody of client assets
to obtain an annual surprise examination from an
independent public accountant. An adviser to a
pooled investment vehicle that is subject to an
annual financial statement audit by a PCAOBregistered independent public accountant that is
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Federal Register / Vol. 87, No. 57 / Thursday, March 24, 2022 / Proposed Rules
advised by RIAs undergo financial
statement audits with similarly high
frequency, with the exception of
securitized asset funds, of which fewer
Fund type
Total funds
than 20 percent are audited according to
the recent ADV data.
Unaudited
funds
Unaudited
%
Audited
%
Hedge Fund .....................................................................................................
Liquidity Fund ..................................................................................................
Other Private Fund ..........................................................................................
Private Equity Fund .........................................................................................
Real Estate Fund .............................................................................................
Securitized Asset Fund ....................................................................................
Venture Capital Fund .......................................................................................
11,508
86
5,452
18,820
4,174
2,273
2,065
431
10
545
1,167
518
1,931
380
3.7
11.6
10.0
6.2
12.4
85.0
18.4
96.3
88.4
90.0
93.8
87.6
15.0
81.6
Unique Totals ...........................................................................................
44,378
4,982
11.2
88.8
Source: Form ADV, Schedule D, Section 7.B.(1) filed between Oct 1st, 2020 and Sep 30th, 2021.
These audits, while currently valuable
to investors, do not obviate the issues
with fee, expense, and performance
reporting discussed above.287 First, as
shown in the table above, not all funds
advised by RIAs currently undergo
annual financial statement audits.
Second, statements regarding fees,
expenses, and performance tend to be
more frequent, and thus more timely,
than audited annual financial
statements. Lastly, more frequent fee,
expense, and performance disclosures
can include incremental and more
granular information that would be
useful to investors and that would not
typically be included in an annual
financial statement.288
Regarding fairness opinions, our staff
has observed a recent rise in adviser-led
secondary transactions where an adviser
offers fund investors the option to sell
their interests in the private fund or to
exchange them for new interests in
another vehicle advised by the
adviser.289 We understand that some,
but not all, advisers obtain fairness
opinions in connection with these
transactions that typically address
whether the price offered is fair. These
fairness opinions provide investors with
some third-party assurance as a means
to help protect participating investors.
all advisers make and retain such
documentation of the annual review.
C. Benefits and Costs
1. Overview and Broad Economic
Considerations
The books and records rule includes
requirements for recordkeeping to
promote, and facilitate internal and
external monitoring of, compliance. For
example, the books and records rule
requires advisers registered or required
to be registered under Section 203 of the
Under the Advisers Act compliance
rule, advisers registered or required to
be registered under Section 203 of the
Act must review no less frequently than
annually the adequacy of their
compliance policies and procedures and
the effectiveness of their
implementation. Currently, there is no
requirement to document that review in
writing.292 This rule applies to all
investment advisers, not just advisers to
private funds.293 We understand that
many investment advisers routinely
make and preserve written
documentation of the annual review of
their compliance policies and
procedures, even while the compliance
rule does not require such written
documentation. Many advisers retain
such documentation for use in
demonstrating compliance with the rule
during an examination by our Division
of Examinations. However, based on
staff experience, we understand that not
Private fund investments can be
opaque, and we have observed that
investors lack sufficiently detailed
information about fund fees and
expenses and the preferred terms
granted to certain investors and often
lack sufficient transparency into how
private fund performance is calculated.
In addition, we have observed that
certain sales practices, conflicts of
interest, and compensation schemes are
either not transparent to investors or can
be harmful and have significant negative
effects on private fund returns.
The proposed rules would (a) require
registered investment advisers to
provide certain disclosures in quarterly
statements to private fund investors, (b)
require all investment advisers,
including those that are not registered
with the Commission, to make certain
disclosures of preferential terms offered
to prospective and current investors, (c)
prohibit all private fund advisers,
including those that are not registered
with the Commission, from engaging in
certain activities with respect to the
private fund or any investor in that
private fund, (d) require a registered
private fund adviser to obtain an annual
financial statement audit of a private
fund and, in connection with an
adviser-led secondary transaction, a
fairness opinion from an independent
opinion provider, and (e) impose further
subject to regular inspection is not, however,
required to obtain an annual surprise examination
if the vehicle distributes the audited financial
statements prepared in accordance with generally
accepted accounting principles to the pool’s
investors within 120 days of the end of its fiscal
year. See rule 206(4)–2(b)(4).
287 See supra section V.B.3.
288 For example, annual financial statements may
not include both gross and net IRRs and MOICs,
separately for realized and unrealized investments,
and without the impact of fund-level subscription
facilities. Annual financial statements may also
vary in the level of detail provided for portfolio
investment-level compensation. See, e.g.,
Illustrative Financial Statements: Private Equity
Funds, KPMG (November 2020), available at
https://audit.kpmg.us/content/dam/advisory/en/
pdfs/2020/financial-statements-private-equityfunds-2020.pdf; Illustrative Financial Statements:
Hedge Funds, KPMG (November 2020), available at
https://audit.kpmg.us/content/dam/advisory/en/
pdfs/2020/financial-statements-hedge-funds2020.pdf.
289 See supra section II.B.
290 See rule 204–2 under the Advisers Act.
291 See rule 204–2(e)(1) under the Advisers Act.
292 Advisers Act rule 206(4)–7.
293 Id.
5. Books and Records
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Act to make and keep true, accurate and
current certain books and records
relating to their investment advisory
businesses, including advisory business
financial and accounting records, and
advertising and performance records.290
Advisers are required to maintain and
preserve these records in an easily
accessible place for a period of not less
than five years from the end of the fiscal
year during which the last entry was
made on such record, the first two years
in an appropriate office of the
investment adviser.291
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requirements, including certain
requirements that apply to all fund
advisers, to enhance the level of
regulatory and other external
monitoring of private funds and other
clients.
Without Commission action, private
funds and private fund advisers would
have limited abilities and incentives to
implement effective reform. First, it may
be difficult for private funds to adopt a
common, standardized set of detailed
disclosures and practices. This is
because investors and advisers compete
and negotiate independently of each
other, and also because of the
substantial complexity of information
that fund advisers maintain on their
funds and may potentially disclose. For
example, and as discussed above,
developing an industry standard on fee
and expense disclosures would require
independent and competing investors
and advisers to determine which of
management fees, fund expenses,
performance-based compensation,
monitoring fees, and more should be
disclosed and at what frequency.294
Investors and advisers would face
substantial costs in developing a single
industry standard that encompasses all
of the dimensions considered in this
proposal.
Second, fund adviser incentives to
develop and implement reforms, such as
developing more detailed disclosures,
are limited by principal-agent problems
that are inherent to the relationship
between fund advisers and clients.295
Advisers to private funds can
potentially engage in opportunistic
behavior (‘‘hold up’’) toward the client
in which they exploit their
informational advantage or bargaining
power over the client, after the client
has entered into the relationship.296
Advisers may also face scenarios in
294 See
supra section V.B.3.
relationship between an adviser and its
client or a fund and its investor is generally one
where the principal (the client, here a fund) relies
on an agent (the investment adviser) to perform
services on the principal’s behalf. See Michael C.
Jensen & William H. Meckling, Theory of the Firm:
Managerial Behavior, Agency Costs and Ownership
Structure, 3 Journal of Financial Economics 305–
360 (1976). To the extent that principals and their
agents do not have perfectly aligned preferences
and goals, agents may take actions that increase
their well-being at the expense of principals,
thereby imposing ‘‘agency costs’’ on the principals.
Principals may seek contractual solutions to the
principal-agent problem, although these solutions
may be limited in the presence of information
asymmetry.
296 The potential for exploitation can be reduced
to the extent that investors have strong rights of
exit. See, e.g., John Morley, The Separation of
Funds and Managers: A Theory of Investment Fund
Structure and Regulation, 123 (5) Yale Law Journal
1228–1287 (2014), available at https://openyls.law.
yale.edu/bitstream/handle/20.500.13051/4449/
123YaleLJ.pdf?sequence=2&isAllowed=y.
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295 The
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which they have conflicts of interest
between certain investors and their own
interests (or ‘‘conflicting
arrangements’’), reducing their
incentives to act in the investors’ best
interests. Advisers may not have
sufficient incentives and abilities to
commit to a solution to these problems
with existing governance mechanisms.
These problems of information
asymmetry and post-contractual holdup are amplified by the inherent
discretion that private fund advisers
have over what information to disclose
to prospective investors and the
complexity of the disclosures that they
provide. In addition, the incentives of
advisers to provide investors with
transparency are limited and may
depend on the investor’s scale of
operations or relationship with the
adviser. For example, the adviser of a
private fund may choose not to disclose
to smaller investors information
regarding the preferred terms that are
granted to larger investors, even when
those terms are material to smaller
investor’s choices regarding the fund
investment.297
These issues carry costs and risks of
investor harm in financial markets. The
relationship between fund adviser and
investor can provide valuable
opportunities for diversification of
investments and an efficient avenue for
the raising of capital, enabling economic
growth that would not otherwise occur.
However, the current opacity of the
market can prevent even sophisticated
investors from optimally obtaining
certain terms of agreement from fund
advisers, and this can result in investors
paying excess costs, bearing excess risk,
receiving limited and less reliable
information about investments, and
receiving contractual terms that may
reduce their returns relative to what
they would obtain otherwise. The
proposed rules provide a regulatory
solution that addresses these problems
and enhances the protection of
investors. Moreover, the proposed rules
do so in a way that does not deprive
fund advisers of compensation for their
services: Insofar as the proposed rules
shift costs and risks back onto fund
advisers, the rules strengthen the
incentives of advisers to manage risk in
the interest of fund investors and, in
doing so, does not preclude fund
advisers from responding by raising
297 Results from studies of other markets suggest
that mandatory disclosures can cause managers to
focus more narrowly on maximizing investor value.
See, e.g., Michael Greenstone, Paul Oyer, and
Annette Vissing-Jorgensen, Mandated Disclosure,
Stock Returns, and the 1964 Security Acts
Amendments, 121 (2) The Quarterly Journal of
Economics 399–460 (May 2006).
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16943
prices of services that are not prohibited
and are appropriately, transparently
disclosed.
Effects. In analyzing the effects of the
proposed rules, we recognize that
investors may benefit from access to
more useful information about the fees,
expenses, and performance of private
funds. They also may benefit from more
intensive monitoring of funds and fund
advisers by third parties, including
auditors and persons who prepare
assessments of secondary transactions.
Finally, investors may benefit from the
prohibition of certain sales practices,
conflicts of interest, and compensation
schemes that result in investor harm.
We recognize that the specific
provisions of the proposed rules would
benefit investors through each of these
basic effects.
More useful information for investors.
Investors rely on information from fund
advisers in deciding whether to
continue an investment, how strictly to
monitor an ongoing investment or their
adviser’s conduct, whether to consider
switching to an alternative, whether to
continue investing in subsequent funds
raised by the same adviser, and how to
potentially negotiate terms with their
adviser on future investments.298 By
requiring detailed and standardized
disclosures across certain funds, the
proposal would improve the usefulness
of the information that current investors
receive about private fund fees,
expenses, and performance, and that
both current and prospective investors
receive about preferential terms granted
to certain investors. This would enable
them to evaluate more easily the
performance of their private fund
investments, net of fees and expenses,
and to make comparisons among
investments. Finally, enhanced
disclosures would help investors shape
the terms of their relationship with the
adviser of the private fund. The rules
may also improve the quality and
accuracy of information received by
investors through the proposed audit
requirement, both by providing
independent checks of financial
statements, and by potentially
improving advisers’ regular performance
reporting, to the extent that regular
audits improve the completeness and
accuracy of fund adviser valuation of
ongoing investments.
Enhanced external monitoring of fund
investments. Many investors currently
rely on third-party monitoring of funds
298 For example, private equity fund agreements
often allow the adviser to raise capital for new
funds before the end of the fund’s life, as long as
all, or substantially all, of the money in prior fund
has been invested. See, e.g., Gompers and Lerner
(2004) and Morley (2014, at 1254).
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for prevention and timely detection of
specific harms from misappropriation,
theft, or other losses to investors. This
monitoring occurs through audits and
surprise exams or audits under the
custody rule, as well as through other
audits of fund financial statements. The
proposal would expand the scope of
circumstances requiring third-party
monitoring, and investors would benefit
to the extent that such expanded
monitoring increases the speed of
detection of misappropriation, theft, or
other losses and so results in more
timely remediation. Audits may also
broadly improve the completeness and
accuracy of fund performance reporting,
to the extent these audits improve fund
valuations of their ongoing investments.
Even investors who rely on the
recommendations of consultants,
advisers, private banks, and other
intermediaries would benefit from the
proposal, to the extent the
recommendations by these
intermediaries are also improved by the
protections of expanded third-party
monitoring by independent public
accountants.
Prohibitions of certain activities that
are contrary to public interest and to the
protection of investors. Certain
practices, even if appropriately
disclosed or permitted by private fund
offering documents, represent potential
conflicts of interest and sources of harm
to funds and investors. Because many of
these conflicts of interest and sources of
harm may be difficult for investors to
detect or negotiate terms over, full
disclosure of the activities considered in
the proposal would not likely resolve
the potential investor harm. Further, as
discussed above, private funds typically
lack fully independent governance
mechanisms more common to other
markets that would help protect
investors from harm in the context of
the activities considered.299 The
proposal would benefit investors and
serve the public interest by prohibiting
such practices.
The costs of the proposed rules would
include the costs of meeting the
minimum regulatory requirements of
the rules, including the costs of
providing standardized disclosures and,
for some funds, refraining from
prohibited activities, and obtaining the
required external financial statement
audit and fairness opinions. Additional
costs would arise from the new
compliance requirements of the
proposed rules. For example, some
advisers would update their compliance
programs in response to the requirement
to make and keep a record of their
299 See
supra section V.B.1.
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annual review of the program’s
implementation and effectiveness.
Certain fund advisers may also face
costs in the form of declining revenue,
declining in compensation to fund
personnel and a potential resulting loss
of employees, or losses of investor
capital. However, some of these costs,
such as declining compensation to fund
personnel, would be a transfer to
investors depending on the fund’s
economic arrangement with the adviser.
Below we discuss these benefits and
costs in more detail and in the context
of the specific elements of the proposal.
2. Quarterly Statements
We are proposing to require a
registered investment adviser to prepare
a quarterly statement for any private
fund that it advises, directly or
indirectly, that has at least two full
calendar quarters of operating results,
and distribute the quarterly statement to
the private fund’s investors within 45
days after each calendar quarter end,
unless such a quarterly statement is
prepared and distributed by another
person.300 The rule provides that, to the
extent doing so would provide more
meaningful information to the private
fund’s investors and would not be
misleading, the adviser must
consolidate the quarterly statement
reporting to cover, as defined above,
substantially similar pools of assets.301
We discuss the costs and benefits of
this proposal to require a quarterly
account statement below. The
Commission notes, however, that it is
generally difficult to quantify these
economic effects with meaningful
precision, for a number of reasons. For
example, there is a lack of quantitative
data on the extent to which advisers
currently provide information that
would be required to be provided under
the proposed rule to investors. Even if
these data existed, it would be difficult
to quantify how receiving such
information from advisers may change
investor behavior. In addition, the
benefit from the requirement to provide
the mandated performance disclosures
would depend on the extent to which
investors already receive the mandated
information in a clear, concise, and
comparable manner. As discussed
above, however, we believe that the
format and scope of these disclosures
vary across advisers and private funds,
with some disclosures providing limited
information while others are more
detailed and complex.302 As a result,
supra section II.A.
supra section II.A.4.
302 See supra section V.B.3.
parts of the discussion below are
qualitative in nature.
Quarterly Statement—Fee and Expense
Disclosure
The proposed rule would require an
investment adviser that is registered or
required to be registered and that
provides investment advice to a private
fund to provide to each of the private
fund investors with a quarterly
statement containing certain
information regarding fees and
expenses, including fees and expenses
paid by underlying portfolio
investments to the adviser or its related
persons, is distributed to the fund’s
investors. The quarterly statement
would include a table detailing all
adviser compensation to advisers and
related persons, fund expenses, and the
amount of offsets or rebates carried
forward to reduce future payments or
allocations to the adviser or its related
persons.303 Further, the quarterly
statement would include a table
detailing portfolio investment
compensation and, for portfolio
investments in which portfolio
investment compensation was received,
certain ownership percentage
information.304 The proposed quarterly
statement rule would require each
quarterly statement to be distributed
within 45 days, include clear and
prominent, plain English disclosures
regarding the manner in which all
expenses, payments, allocations,
rebates, waivers, and offsets are
calculated, and include cross-references
to the sections of the private fund’s
organizational and offering documents
that set forth the applicable calculation
methodology.305
Benefits
The effect of this requirement to
provide a standardized minimum
amount of information in an easily
understandable format would be to
lower the cost to investors of monitoring
fund fees and expenses, lower the cost
to investors of monitoring any
conflicting arrangements, improve the
ability of investors to negotiate terms
related to the governance of the fund,
and improve the ability of investors to
evaluate the value of services provided
by the adviser and other service
providers to the fund.
For example, investors could more
easily compare actual investment
returns to the projections they received
prior to investing. As discussed above,
any waterfall arrangements governing
300 See
303 See
301 See
304 See
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supra section II.A.1.a.
supra section II.A.1.b.
305 See supra section II.A.1.c.
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fund adviser compensation may be
complex and opaque.306 As a result,
investor returns from a fund may be
affected by whether investors are able to
follow, and verify, payments that the
fund is making to investors and to the
adviser in the form of performancebased compensation, as these payments
are often only made after investors have
recouped the applicable amount of
capital contributions and received any
applicable preferred returns from the
fund. This information may also help
investors evaluate whether they are
entitled to the benefit of a clawback.
This may particularly be the case for
deal-by-deal waterfalls, where advisers
may be more likely to be subject to a
clawback.307 As discussed above, even
sophisticated investors have reported
difficulty in measuring and evaluating
compensation made to fund advisers
and determining if adviser fees comply
with the fund’s governing
agreements.308 Any such investors
would benefit to the extent that the
required disclosures under the proposal
address these difficulties.
Investors may also find it easier to
compare alternative funds or other
investments. As a result, some investors
may reallocate their capital among
competing fund investments and, in
doing so, achieve a better match
between their choice of private fund and
their preferences over private fund
terms, investment strategies, and
investment outcomes. For example,
investors may discover differences in
the cost of compensating advisers across
funds that lead them to move their
assets into funds (if able to do so) with
less costly advisers or other service
providers. Investors may also have an
improved ability to negotiate expenses
and other arrangements in any
subsequent private funds raised by the
same adviser. Investors may therefore
face lower overall costs of investing in
private funds as a benefit of the
standardization. In addition, an investor
may more easily detect errors by reading
the adviser’s disclosure of any offsets or
rebates carried forward to subsequent
periods that would reduce future
adviser compensation. This information
would make it easier for investors to
understand whether they are entitled to
additional reductions in future periods.
Because the rule requires disclosures
at both the private-fund level and the
portfolio level, investors can more easily
evaluate the aggregate fees and expenses
of the fund, including the impact of
306 See
supra section V.B.3.
307 Id.
308 See
supra footnote 24 (with accompanying
text).
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individual portfolio investments. The
private fund level information would
allow investors to more easily evaluate
their fund fees and expenses relative to
the fund governing documents, evaluate
the performance of the fund investment
net of fees and expenses, and evaluate
whether they want to pursue further
investments with the same adviser or
explore other potential investments. The
portfolio investment level information
would allow investors to evaluate the
fees and costs of the fund more easily
in relation to the adviser’s
compensation and ownership of the
portfolio investments of the fund. For
example, investors would be able to
evaluate more easily whether any
portfolio investments are providing
compensation that could entitle
investors to a rebate or offset of the fees
they owe to the fund adviser. This
information would also allow investors
to compare the adviser’s compensation
from the fund’s portfolio investments
relative to the performance of the fund
and relative to the performance of other
investments available to the investor. To
the extent that this heightened
transparency encourages advisers to
make more substantial disclosures to
prospective investors, investors may
also be able to obtain more detailed fee
and expense and performance data for
other prospective fund investments. As
a result of these required disclosures,
investor choices over private funds may
more closely match investor preferences
over private fund terms, investment
strategies, and investment outcomes.
The magnitude of the effect depends
on the extent to which investors do not
currently have access to the information
that would be reported in the quarterly
statement in an easily understandable
format. While many advisers not
required to send quarterly statements
choose to do so anyway, existing
quarterly statements are not
standardized across advisers and may
vary in their level of detail. For
example, we understand that many
private equity fund governing
agreements are broad in their
characterization of the types of expenses
that may be charged to portfolio
investments and that investors receive
reports of fund expenses that are
aggregated to a level that makes it
difficult for investors to verify that the
individual charges to the fund are
justified.309 Further, as discussed above,
we believe that some investors in hedge
309 See, e.g., StepStone, Uncovering the Costs and
Benefits of Private Equity (Apr. 2016), available at
https://www.stepstonegroup.com/wp-content/
uploads/2021/07/StepStone_Uncovering_the_
Costs_and_Benefits_of_PE.pdf.
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funds operating in reliance on the
exemption set forth in CFTC Regulation
4.7 may currently receive quarterly
statements that present, among other
things, the net asset value of the exempt
pool and the change in net asset value
from the end of the previous reporting
period.310 While this could have the
effect of mitigating some of the benefits
of the proposed rule, we do not believe
that reports provided to investors
pursuant to CFTC Regulation § 4.7
require all of the information, nor their
standardized presentation, as required
under the proposed rule. The magnitude
of the effect also depends on how
investors would use the fee and expense
information in the quarterly statement.
In addition, reports of fund expenses
often do not include data about
payments at the level of portfolio
investments, information about the
extent to which fees and expenses are
allocated to a given fund versus other
similar funds and co-investment
accounts, or about how offsets are
calculated, allocated and applied. Lack
of disclosure has been at issue in
enforcement actions against fund
managers.311
Costs
The cost of the proposed changes in
fee and expense disclosure would
include the cost of compliance by the
adviser. For advisers that currently
maintain the records needed to generate
the required information, the cost of
complying with this new disclosure
requirement would be limited to the
costs of compiling, preparing, and
distributing the information for use by
investors and the cost of distributing the
information to investors. We expect
these costs would generally be ongoing
costs. Advisers would also incur costs
associated with determining and
verifying that the required disclosures
comply with the format requirements
under the proposed rule, including
demands on personnel time required to
verify that disclosures are made in plain
English regarding the manner in which
calculations are made and to verify that
disclosures include cross-references to
the sections of the private fund’s
organizational and offering documents.
This also includes demands on
personnel time to verify that the
information required to be provided in
tabular format is distributed with the
correct presentation. Advisers may also
choose to undertake additional costs of
ensuring that all information in the
quarterly statements is drafted
310 See
supra section V.B.3.
supra footnotes 25–27 (with
accompanying text).
311 See
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consistently with the information in
fund offering documents, to avoid
inconsistent interpretations across fund
documents and resulting confusion for
investors. Many of these costs we would
expect would be borne more heavily in
the initial compliance phases of the rule
and would wane on an ongoing basis.
Some of these costs of compliance
could be reduced by the rule provision
providing that advisers must
consolidate the quarterly statement
reporting to cover substantially similar
pools of assets, avoiding duplicative
costs across multiple statements.
However, in other cases the rule
provision requiring consolidation may
further increase the costs of compliance
with the proposed rules, not decrease
the costs of compliance. For example, in
the case where a private fund adviser is
preparing quarterly statements for
investors in a feeder fund, and therefore
consolidating statements between a
master fund and its feeder funds, the
consolidation may require the adviser to
calculate the feeder fund’s proportionate
interest in the master fund on a
consolidated basis. The additional costs
of these calculations of proportionate
interest in the master fund, to the extent
the adviser does not already undertake
this practice, may offset any reduced
costs the adviser receives from not being
required to undertake duplicative costs
across multiple statements.
There are other aspects of the rule that
would impose costs. The proposed rule
would require each portfolio investment
table to list the fund’s ownership
percentage of covered portfolio
investments as of the end of the
reporting period and impose recordkeeping and timing requirements. The
costs associated with implementing this
requirement are likely to vary among
advisers depending on the current
record keeping and disclosure practices
of the adviser. These costs are likely to
be initially higher, but could also vary
over time. In addition, some advisers
may choose to update their systems and
internal processes and procedures for
tracking fee and expense information in
order to better respond to this disclosure
requirement. The costs of those
improvements would be an indirect cost
of the rule, to the extent they would not
occur otherwise, and they are likely to
be higher initially than they would be
on an ongoing basis.
Preparation and distribution of
Quarterly Statements. As discussed
below, for purposes of the Paperwork
Reduction Act of 1995 (‘‘PRA’’), we
anticipate that the compliance costs
associated with preparation and
distribution of quarterly statements
(including the preparation and
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distribution of fee and expense
disclosure, as well as the performance
disclosure discussed below) would
include an aggregate annual internal
cost of $200,643,858 and an aggregate
annual external cost of $112,403,250, or
a total cost of $313,047,108 annually.312
For costs associated with potential
upgrades to fee tracking and expense
information systems, funds are likely to
vary in the intensity of their upgrades,
because for example some advisers may
not pursue any system upgrades at all,
and moreover the costs may be pursued
or amortized over different periods of
time. Advisers are similarly likely to
vary in their choices of whether to
invest in increasing the quality of their
services. For both of these categories of
costs, the data do not exist to estimate
how funds or investors may respond to
the reporting requirements, and so the
costs may not be practically quantified.
Under the proposed rule, these
compliance costs may be borne by
advisers and, where permissible, could
be imposed on funds and therefore
indirectly passed on to investors. For
example, under current practice,
advisers to private funds generally
charge disclosure and reporting costs to
the funds, so that those costs are
ultimately paid by the fund investors.
Also, currently, to the extent advisers
use service providers to assist with
preparing statements (e.g., fund
administrators), those costs often are
borne by the fund (and thus indirectly
investors). To the extent not prohibited,
we expect similar arrangements may be
made going forward to comply with the
proposed rule. Advisers could
alternatively attempt to introduce
substitute charges (for example,
increased management fees) in order to
cover the costs of compliance with the
rule, and their ability to do so may
depend on the willingness of investors
to incur those substitute charges.
Further, to the extent that the
additional standardization and
comparability of the information in the
required disclosures makes it more
difficult to charge fees higher than those
charged for similar adviser services or
otherwise to continue current levels and
structures of fees and expenses, the
proposal may reduce revenues for some
advisers and their related persons.
These advisers may respond by
reducing their fees or by differentiating
their services from those provided by
other advisers, including by, for
example, increasing the quality of their
312 See infra section VI.B. As explained in that
section, this estimated annual cost is the sum of the
estimated recurring cost of the proposed rule in
addition to the estimated initial cost annualized
over the first three years.
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services in a manner that could attract
additional capital to funds they advise.
To the extent these reduced revenues
result in reduced compensation for
some advisers and their related persons,
those entities may become less
competitive as employers. However, this
cost is likely to be mitigated because
some advisers may attract new capital
under the proposal, and so those
advisers and their related persons may
become more competitive as employers.
Quarterly statement—Performance
Disclosure
Advisers would also be required to
include standardized fund performance
information in each quarterly statement
provided to fund investors. Specifically,
the proposed rule would require an
adviser to a fund considered a liquid
fund under the proposed rule to
disclose the fund’s annual total returns
for each calendar year since inception
and the fund’s cumulative total return
for the current calendar year as of the
end of the most recent calendar quarter
covered by the quarterly statement.313
For funds determined to be illiquid
funds under the proposed rule, the
proposed rule would require an adviser
to show the internal rate of return (IRR)
and multiple of invested capital (MOIC)
(each, on a gross and net basis), the
gross IRR and the gross MOIC for the
unrealized and realized portions of the
portfolio (each shown separately), and a
statement of contributions and
distributions.314 Each would be
computed without the effect of any fund
level subscription facilities.315 The
statement of contributions and
distributions would provide certain
cash flow information for each fund.316
Further, advisers would be required to
include clear and prominent plain
English disclosure of the criteria used
and assumptions made in calculating
the performance.317
Benefits
As a result of these performance
disclosures, some investors would find
it easier to obtain and use information
about the performance of their private
fund investments. They may, for
example, find it easier to monitor the
performance of their investments and
compare the performance of the private
funds in their portfolios to each other
and to other investments. In addition,
they may use the information as a basis
for updating their choices between
313 See
314 See
supra section II.A.2.a.
supra section II.A.2.b.
315 Id.
316 Id.
317 See
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different private funds or between
private fund and other investments. In
doing so, they may achieve a better
alignment between their investment
choices and preferences. Cash flow
information would be provided in a
form that allows investors to compare
the performance of the fund (or a fund
investment) with the performance of
other investments, such as by
computing PME or other metrics.
We understand that some investors
receive the required performance
information under the baseline,
independently of the proposed rule. For
example, some investors receive
performance disclosures from advisers
on a tailored basis. Those investors may
not experience easier access to
performance information from the
proposal. They may, however, benefit
from standardization of the information
in quarterly statements across investors
in a fund and across advisers. For
example, the standardization of the data
that a fund provides to all of its
investors could benefit some investors
by facilitating the development and
sharing of tools and methods for
analyzing the data among the various
investors of the fund. In addition, to the
extent that investors share the complete,
comparable data with consultants or
other intermediaries they work with (as
is often current practice to the extent
permitted under confidentiality
provisions), this may allow such
intermediaries to provide broader views
across the private funds market or
segments of the market. This may
facilitate better decision making and
capital allocation more broadly.
The required presentation of
performance information and the
resulting economic benefits would vary
based on whether the fund is
determined to be a liquid fund or an
illiquid fund. For example, for private
equity and other funds determined to be
illiquid funds, investors would benefit
from receiving multiple pieces of
performance information, because the
shortcomings discussed above that are
associated with each method of
measuring performance make it difficult
for investors to evaluate fund
performance from any singular piece of
performance information alone, such as
IRR or MOIC.318 For hedge funds, the
primary benefit is the mandating of
regular reporting of returns by advisers,
avoiding any potential biases associated
with hedge funds choosing whether and
when to report returns.319 The benefits
from the proposed requirements are
therefore potentially more substantial
318 See
supra section V.B.3.
319 Id.
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for the funds determined to be illiquid
funds, as the breadth of the performance
information that would be required
under the proposal for the private equity
and other funds determined to be
illiquid funds is designed to address the
shortcomings of individual performance
metrics. For both types of funds,
because the factors we propose to use to
distinguish between liquid and illiquid
funds align with the current factors for
determining how certain types of
private funds should report performance
under U.S. GAAP, market participants
may be more likely to understand the
presentation of performance.
Costs
The cost of the required performance
disclosure by fund advisers would vary
according to the existing practices of the
adviser and the complexity of the
required disclosure. For advisers who
already (under their current practice)
incur the costs of generating the
necessary performance data, presenting
and distributing it in a format suitable
for disclosure to investors, and checking
the disclosure for accuracy and
completeness, the cost would likely be
small. In particular, for those advisers,
the cost of the performance disclosure
may be limited to the cost of
reformatting the performance
information for inclusion in the
mandated quarterly report. However, we
understand that some advisers may face
costs of changing their performance
tracking or reporting practices under the
current rule. Some of these costs would
be direct costs of the rule requirements.
Costs of updating an adviser’s internal
controls or internal compliance system
to verify the accuracy and completeness
of the reported performance information
would be indirect costs of the rule. We
expect the bulk of the costs associated
with complying with this aspect of the
proposed rules would likely be most
substantial initially rather than on an
ongoing basis.320
Some of these costs of compliance
could again be affected by the rule
provision providing that advisers must
consolidate the quarterly statement
reporting to cover substantially similar
pools of assets. These costs of
compliance would be reduced to the
extent that advisers are able to avoid
duplicative costs across multiple
statements, but would be increased to
the extent that advisers must undertake
costs associated with calculating feeder
fund proportionate interests in a master
320 The quantification of the direct costs
associated with completing performance
disclosures is included in the analysis of costs
associated with fee and expense disclosures above.
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16947
fund, to the extent advisers do not
already do so.
The required presentation of
performance, and the resulting costs,
would vary based on whether the fund
is categorized as liquid or illiquid. In
particular, for funds determined to be
liquid funds, the cost is mitigated by the
limited nature of the required
disclosure, as the proposal requires only
annual total returns and cumulative
total returns for the current calendar
year as of the end of the most recent
calendar quarter covered, while the
more detailed required disclosures for
funds determined to be illiquid funds
may require greater cost (yielding, as
just discussed, greater benefit).321 For
both categories of funds, because the
factors we proposed to use to
distinguish between liquid and illiquid
funds align with the current factors for
determining how certain types of
private funds should report performance
under U.S. GAAP, and as a result,
market participants may be more
familiar with these methods of
presenting information, which may
mitigate costs.
Under the proposed rule, these
compliance costs may be borne by
advisers and, where permissible, could
be imposed on funds and therefore
indirectly passed on to investors. For
example, under current practice,
advisers to private funds generally
charge disclosure and reporting costs to
the funds, so that those costs are
ultimately paid by the fund investors.
Similarly, to the extent advisers
currently use service providers to assist
with performance reporting (e.g.,
administrators), those costs are often
borne by the fund (and thus investors).
To the extent not prohibited, we expect
similar arrangements may be made
going forward to comply with the
proposed rule. Advisers could
alternatively attempt to introduce
substitute charges (for example,
increased management fees) in order to
cover the costs of compliance with the
rule, but their ability to do so may
depend on the willingness of investors
to incur those substitute charges.
Further, to the extent that the
additional standardization and
comparability of the information in the
required disclosures make it easier for
investors to compare and evaluate
performance, the rule may prompt some
investors to search for and seek higher
performing investment opportunities.
This could reduce the ability for
advisers of low-performing funds to
attract additional capital. By the same
rationale, the rule may prompt some
321 See
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investors to search for and seek higher
performing investment opportunities,
further reducing the ability for advisers
of low-performing funds to attract
additional capital.
3. Prohibited Activities and Disclosure
of Preferential Treatment
The proposed rules would prohibit a
private fund adviser from engaging in
certain activities with respect to the
private fund or any investor in that
private fund, including (i) charging
certain regulatory and compliance fees
and expenses or fees or expenses
associated with certain examinations or
investigations,322 (ii) charging fees for
certain unperformed services,323 (iii)
certain non-pro rata fee and expense
allocations,324 (iv) borrowing money,
securities, or other fund assets, or
receiving a loan or an extension of
credit, from a private fund client,325 (v)
reducing the amount of any adviser
clawback by the amount of certain
taxes,326 (vi) limiting or eliminating
liability for certain adviser
misconduct,327 and (vii) granting an
investor in the private fund or a
substantially similar pool of assets
preferential terms regarding liquidity or
transparency that the adviser reasonably
expects to have a material, negative
effect on other investors in the fund or
a substantially similar pool of assets.328
In addition, we also propose to prohibit
all private fund advisers from providing
any other preferential treatment to any
investor in the private fund unless the
adviser provides written disclosures to
prospective and current investors.329
These prohibitions would apply to
activities of the private fund advisers
even if they are performed indirectly,
for example, by an adviser’s related
persons, recognizing that the potential
for harm to the fund and its investors
arises independently of whether the
adviser engages in the activity directly
or indirectly.330
We discuss the costs and benefits of
each of these prohibitions and
requirements below. The Commission
notes, however, that several factors
make the quantification of many of
these economic effects of the proposed
amendments and rules difficult. For
example, there is a lack of data on the
extent to which advisers engage in
certain of the activities that would be
supra section II.D.2.
323 See supra section II.D.1.
324 See supra section II.D.5.
325 See supra section II.D.6.
326 See supra section II.D.3.
327 See supra section II.D.4.
328 See supra section II.E.
329 Id.
330 See supra section II.D, II.E.
18:08 Mar 23, 2022
Certain Fees and Expenses
The proposal would prohibit a private
fund adviser from charging the fund for
fees or expenses associated with an
examination or investigation of the
adviser or its related persons by any
governmental or regulatory authority or
for the regulatory and compliance fees
and expenses of the adviser or its
related persons.331 The benefit to
investors would be to lower charges on
the funds they have invested in, which
could increase returns, and potentially
lower the cost of effort to avoid and
evaluate such charges, or a combination
of these benefits. To the extent that
these charges, even when disclosed,
create adverse incentives for advisers to
allocate expenses to the fund at a cost
to the investor, they represent a possible
source of investor harm. For example,
when these charges are in connection
with an investigation of an adviser, it
may not be in the fund’s best interest to
bear the cost of the investigation.332
These fees may also, even when
disclosed, incentivize advisers to engage
in excessive risk-taking, as the adviser
will no longer bear the cost of any
ensuing government or regulatory
examinations or investigations.333 By
331 See
supra section II.D.2.
332 Id.
333 Fund adviser fees can allow the adviser to
obtain leverage, and thereby gain disproportionately
from successes, encouraging advisers to take on
additional risk. See, e.g., Alon Brav, Wei Jiang, and
Rongchen Li, Governance by Persuasion: Hedge
Fund Activism and Market-Based Shareholder
Influence, European Corporate Governance
Institute—Finance (Working Paper No. 797/2021)
(December 10, 2021), available at https://ssrn.com/
abstract=3955116 or https://dx.doi.org/10.2139/
ssrn.3955116.
322 See
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prohibited under the proposed rules, as
well as their significance to the
businesses of such advisers. It is,
therefore, difficult to quantify how
costly it would be to comply with the
prohibitions. Similarly, it is difficult to
quantify the benefits of these
prohibitions, because there is a lack of
data regarding how and to what extent
the changed business practices of
advisers would affect investors, and
how advisers may change their behavior
in response to these prohibitions.
Further, there is a lack of data on the
frequency with which advisers grant
certain investors the preferential
treatment that would be prohibited
under the proposed rules, as well as the
frequency with which preferential terms
are currently disclosed to other
investors, as well as how and to what
extent these disclosures affect investor
behavior. As a result, parts of the
discussion below are qualitative in
nature.
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prohibiting this activity, investors
would benefit from the reduced risk of
having to incur costs associated with the
adviser’s adverse incentives, such as
allocating inappropriate expenses to the
fund. Investors would also be able to
search across fund advisers knowing
that these charges would not be assessed
on any fund, which may lead to a better
match between investor choices of
private funds and their preferences over
private fund terms, investment
strategies, and investment outcomes.
The magnitude of the benefit would to
some extent depend on whether
advisers could introduce substitute
charges (for example, increased
management fees), and the willingness
of investors to incur those substitute
charges, for the purpose of making up
any revenue that would be lost to the
adviser from the prohibition. However,
any such substitute charges would be
more transparent to the investor and
would not create the same adverse
incentives as the prohibited charges,
and so investors would likely ultimately
still benefit.
This prohibition would impose direct
costs on advisers from the need to
update their charging and contracting
practices to bring them into compliance
with the new requirements. Advisers
would also incur costs related to this
prohibition, in connection with not
being able to charge private fund clients
for the prohibited expenses. In addition,
advisers may incur indirect costs related
to adapting their business models in
order to identify and substitute nonprohibited sources of revenue. For
example, advisers may identify and
implement methods of replacing the lost
charges from the prohibited practice
with the other sources of fund revenue.
These costs would likely be transitory.
Further, as discussed above, we
understand that certain private fund
advisers, most notably hedge funds and
other funds determined to be liquid
funds,334 that utilize a pass-through
expense model where the private fund
pays for most, if not all, of the adviser’s
expenses in lieu of being charged a
management fee. The proposed rules
would likely prohibit certain aspects of
pass-through expense models or other
similar models in which advisers charge
investors fees associated with certain of
the adviser’s cost of being an investment
adviser. These expenses that would no
longer be passed through to the fund
could represent additional costs to the
fund adviser, unless the adviser
334 See, e.g., Welcome To Hedge Funds’ Stunning
Pass-Through Fees, Seeking Alpha (January 24,
2017), available at https://seekingalpha.com/
article/4038915-welcome-to-hedge-funds-stunningpass-through-fees.
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negotiates a new fixed management fee
to compensate for the new costs. In
addition, any such fund restructurings
that are undertaken would likely impose
costs that would be borne by advisers.
The costs may also be borne partially or
entirely by the private funds, to the
extent permissible or to the extent
advisers are able to compensate for their
costs with substitute charges (for
example, increased management fees).
These costs would likely be transitory.
In addition, investors may incur costs
from this prohibition that take the form
of lower returns from some fund
investments, depending on the extent to
which the prohibition limits the
adviser’s efficiency or effectiveness in
providing the services that generate
returns from those investments. For
example, in the case of pass-through
expense models, fund advisers who
would have to bear new costs of
providing certain services under the
prohibition may reduce or eliminate
those services from the fund in order to
reduce costs, which may be to the
detriment of the fund’s performance or
lead to an increase of compliance risk.
Moreover, to the extent that restructuring a pass-through expense
model of a hedge fund under the
proposal diverts the hedge fund’s
resources away from the hedge fund’s
investment strategy, this could lead to a
lower return to investors in hedge
funds. The cost of lower returns would
be mitigated to the extent that investors
can distinguish and identify those funds
that require restructuring as to how they
collect revenue from investors and use
this information to search for and
identify substitute funds that have
expense models that do not need to be
restructured under the rule and that do
not present the investor with reduced
returns as a result of the rule. Investors
would also need to be able to evaluate
whether these substitute funds would be
likely to present them with better
performance than their current funds.
Any such search costs would be a cost
of the rule. As a result, the cost to
investors may include a combination of
the cost of lower returns and the cost of
avoiding such reductions in returns.
Fees for Unperformed Services
In addition, the proposal would
prohibit a private fund adviser from
charging a portfolio investment for
monitoring, servicing, consulting or
other fees in respect of services that the
adviser does not, or does not reasonably
expect, to provide to the portfolio
investment, such as through an
accelerated payment. As discussed
above, these fees are likely to reflect
conflicts of interest between the fund
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and the adviser that are difficult for the
investor to detect and mitigate.335 For
example, in receiving the accelerated
payment, discussed above, the adviser
imposes a charge for services that it may
not provide.336 An adviser also may
have an incentive to cause the fund to
exit a portfolio investment earlier than
anticipated, which may result in the
fund receiving a lesser return on its
investment.337 Because adviser
misconduct in response to these
incentives may be difficult for investors
to detect, full disclosure of this practice
does not resolve the conflict of interest.
Under the proposed prohibition,
investors would be able to choose
among fund advisers and invest
knowing that they would not face the
costs of such conflicts of interests,
which also may lead to a better match
between investor choices of private
funds and their preferences over private
fund terms, investment strategies, and
investment outcomes.
Investors would also benefit directly
via lower costs from the prohibition
through the elimination of the fees
charged to the fund’s portfolio
investment.338 These cost savings could
be partially mitigated, however, to the
extent that advisers are using portions of
the proceeds from the accelerated
payment to cover costs of services that
benefit the fund client.339
This prohibition would impose direct
costs on advisers from the need to
update their charging and contracting
practices to bring them into compliance
with the new requirements. Advisers
would also incur costs related to this
prohibition in connection with not
being able to receive these charges for
unperformed services. For example,
advisers would incur costs in
connection with not being able to
receive the accelerated payments, and as
a result, advisers could attempt to
replace the accelerated payments with
some new fee or charge. Advisers could,
therefore, incur transitory costs related
to adapting their business models in
order to identify and substitute nonprohibited sources of revenue. These
costs may be particularly high in the
short term to the extent that advisers renegotiate, re-structure and/or revise
certain existing deals or existing
335 See
supra section II.D.1.
336 Id.
337 See
supra section II.D.1
portfolio investments themselves may
also benefit directly from no longer paying these
fees.
339 As discussed above, the proposal would not
prohibit an arrangement where the adviser shifts
100% of the economic benefit of a portfolio
investment fee to the private fund investors,
whether through an offset, rebate, or otherwise. See
supra section II.D.1.
338 The
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economic arrangements in response to
this prohibition.
In addition, investors may incur some
costs from this prohibition that take the
form of lower returns from certain fund
investments, depending on the extent to
which the fund adviser’s loss of revenue
from the prohibited activity diverts
resources away from the fund’s
investment strategy. For example, the
loss of revenue under this prohibition
could cause some advisers to update
their portfolio investment strategies, so
that they are less reliant on the
prohibited fees for revenue. The
advisers could limit their portfolio
investments that are reliant on
accelerated payments for revenue, for
example. This could lead to a cost to
investors in the form of reduced returns
from those investments. Investors could
mitigate this cost to the extent that they
can distinguish and identify those funds
that require restructuring as to how they
collect revenue from investors and use
this information to search for and
identify substitute funds that do not
present the investor with reduced
returns as a result of the rule. Investors
would also need to be able to evaluate
whether these substitute funds would be
likely to present them with better
performance than their current funds.
These alternative search costs would be
a cost of the rule. As a result, the cost
of the prohibition to investors could
thus include a combination of the cost
of lower returns and the cost of avoiding
such reductions in returns.
Certain Non-Pro Rata Fee and Expense
Allocations
The proposal would prohibit a private
fund adviser from charging certain fees
and expenses related to a portfolio
investment (or potential portfolio
investment) on a non-pro rata basis
when multiple private funds and other
clients advised by the adviser or its
related persons have invested (or
propose to invest) in the same portfolio
investment.340
These non-pro rata fee and expense
allocations tend to adversely affect some
investors who are placed at a
disadvantage to other investors. We
associate these practices and
disadvantages with a tendency towards
opportunistic hold-up of investors by
advisers, involving exploitation of an
informational or bargaining
advantage.341 The disadvantaged
investors currently pay greater than
their pro rata shares of fees and
expenses. The disparity may arise from
340 See
supra section II.D.5.
infra (discussing opportunism in the
context of certain preferential treatment).
341 See
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differences in the bargaining power of
different investors. For example, a fund
adviser may have an incentive to assign
lower than pro rata shares of fees and
expenses to larger investors that bring
repeat business to the adviser and
correspondingly lower pro rata shares to
the smaller investors paying greater than
pro rata shares.
Investors could either benefit or face
costs from the resulting revised
apportionment of expenses to the fund
they are invested in, based on whether
their share of expenses is decreased or
increased under the rule. Investing
clients in these portfolio investments
paying greater than pro rata shares of
such fees and expenses would benefit as
a result of lowered fees. However, to the
extent that a client was previously able
to obtain fee and expense allocations at
rates less than a pro rata apportionment,
the client could incur higher fee and
expense costs in the future. Investors
may not be aware of the extent to which
fees are charged on a non pro-rata basis.
Even if disclosed, the complexity of fee
arrangements may mean that these
arrangements are hard to follow. More
sophisticated investors may be aware
that they risk non pro-rata fees, but
nonetheless be harmed by the
uncertainty from complex fee
arrangements. Fund advisers may face a
commitment problem in that they and
their clients might be better off if they
could commit to pro-rata arrangements;
thus a prohibition could serve as a net
benefit to clients and advisers.342
This prohibition would impose direct
costs on advisers to updating their
charging and contracting practices to
bring them into compliance with the
new requirements. These compliance
costs may be particularly high in the
short term to the extent that advisers renegotiate, re-structure, and/or revise
certain existing deals or existing
economic arrangements in response to
this prohibition. Advisers may face
additional costs in the form of lower
expenses and fees, to the extent that less
flexible pro-rata fee and expense
allocations result in lower average fees
and expenses to the adviser or are more
costly to administer and monitor.
Borrowing
The proposal prohibits an adviser,
directly or indirectly, from borrowing
money, securities, or other fund assets,
or receiving a loan or an extension of
credit, from a private fund client.343 In
342 In a related setting, ex ante commitment to a
financing policy has been argued to raise value and
lower the cost of capital. See Peter DeMarzo,
Presidential Address, Collateral and Commitment,
Journal of Finance, (July 15 2019).
343 See supra section II.D.6.
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cases where, as the Commission has
observed, fund assets were used to
address personal financial issues of one
of the adviser’s principals, used to pay
for the advisory firm’s expenses, or used
in association with any other harmful
conflict of interest, 344 then this
prohibition would increase the amount
of fund resources available to further the
fund’s investment strategy. Investors
would benefit from any resulting
increased payout. In addition, investors
would benefit from the elimination or
reduction of any need to engage in
costly research or negotiations with the
adviser to prevent the uses of fund
resources by the adviser that would be
prohibited. The prohibition also has the
potential to benefit investors by
reducing moral hazard: If an adviser
borrows from a private fund client and
does not pay back the loan, it is the
investors who bear the cost, providing
the adviser with incentives to engage in
potentially excessive borrowing.
Advisers may experience costs as a
result of this prohibition related to any
marginal increases in the cost of capital
incurred from new sources of
borrowing, as compared to what was
being charged by the fund.
Reducing Adviser Clawbacks for Taxes
The proposed rule would prohibit
certain uses of fund resources by the
private fund adviser by prohibiting
advisers from reducing the amount of
their clawback obligation by actual,
potential, or hypothetical taxes
applicable to the adviser, its related
persons, or their respective owners or
interest holders.345 Some investors
would benefit from this rule from
effectively increasing clawbacks (and
thus investor returns) by actual,
potential, or hypothetical tax rates.
Investors would also benefit from the
elimination or reduction of any need to
engage in costly research or negotiations
with the adviser to prevent these uses of
fund resources by the adviser. These
benefits would likely be more
widespread, as such research or
negotiations may have been necessary at
the start of fund lives even in cases
where investor returns were not
ultimately impacted by tax treatments of
clawbacks. Advisers, however, may be
unable to recoup the cost of the tax
payments made in connection with the
excess distributions and allocations
affected by the rule, and therefore
would face greater costs when
clawbacks do occur under the
prohibition.
This prohibition would impose direct
costs on advisers of updating their
charging and contracting practices to
bring them into compliance with the
new requirements. Advisers may also
attempt to mitigate the greater costs of
clawbacks under the prohibition by
introducing some new fee, charge, or
other contractual provision that would
make up for the lost tax reduction on
the clawback, and they would then
incur costs of updating their contracting
practices to introduce these new
provisions.
Advisers may attempt to mitigate their
increased costs associated with
clawbacks by reducing the risk of a
clawback occurring. For example,
certain advisers may adopt new
waterfall arrangements designed to
delay carried interest payments until
later in the life of a fund, in order to
limit the possibility of a clawback or
reduce the possible sizes of clawbacks.
In this case, investors would benefit
from earlier distributions of proceeds
from the fund and reduced costs
associated with monitoring their
potential need for a clawback. However,
some fund advisers are able to attract
investors even though their fund terms
do not provide for full or partial
clawbacks. To the extent such advisers
were able to update their business
practices, for example by providing for
an advance on tax payments with no
option for a clawback, this would
reduce the benefit of the proposal, as
investors would continue to receive the
reduced clawback amounts and bear
portions of the adviser’s tax burden. In
either case, advisers would also bear
additional costs from the proposal of
updating their business practices.
Advisers could, therefore, incur
transitory costs related to adapting their
business models in order to identify and
substitute non-prohibited sources of
revenue. These direct costs may be
particularly high in the short term to the
extent that advisers re-negotiate, restructure, and/or revise certain existing
deals or existing economic arrangements
in response to this prohibition.
Limiting or Eliminating Liability for
Adviser Misconduct
In addition, the proposal would
prohibit an adviser to a private fund,
directly or indirectly, from seeking
reimbursement, indemnification,
exculpation, or limitation of its liability
by the private fund or its investors for
a breach of fiduciary duty, willful
misfeasance, bad faith, negligence, or
recklessness in providing services to the
private fund.346 These practices, even
344 Id.
345 See
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when disclosed and permissible under
state law, may involve breaches of
fiduciary duty to the fund or investors,
and possible harms to investors, and so
investors will likely benefit from their
prohibition. For example, because
investors may be unable to anticipate
willful malfeasance by their fund
advisers, they may be unable to
anticipate the costs associated with an
adviser seeking reimbursement for its
malfeasance, even if the adviser
discloses that possibility.347 Investors
would therefore benefit from the
elimination of fund expenses, which
would otherwise reduce investor
returns, associated with reimbursing or
indemnifying the adviser for losses
associated with its malfeasance. These
benefits may be diminished to the
extent that advisers are able to obtain
alternative permissible sources of
compensation for these expenses from
investors (for example, from increased
management fees), although this ability
would likely be limited.
Further, these contractual clauses may
lead investors to believe that they do not
have any recourse in the event of such
a breach. To the extent that any such
investors do not seek damages under
this belief, the contractual clauses
eliminating liability for breach of
fiduciary duty would represent a harm
to the investors. By prohibiting these
scenarios, this proposal could make
such breaches of fiduciary duty
incrementally less likely to occur.
Investors would therefore benefit from a
reduced need to engage in costly
research or negotiations with the adviser
to prevent such breaches.
Certain Preferential Terms
The proposal would prohibit a private
fund adviser from providing certain
preferential terms to some investors that
have a material negative effect on other
investors in the private fund or in a
substantially similar pool of assets. We
associate these practices with a
tendency towards opportunistic hold-up
of investors by advisers, involving the
exploitation of an informational or
bargaining advantage by the adviser or
advantaged investor.348 The proposal
would prohibit a private fund adviser
and its related persons from granting an
investor in the private fund or in a
substantially similar pool of assets the
ability to redeem its interest 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.349 In
347 Id.
348 See
addition, the proposal would prohibit
an adviser and its related persons from
providing information regarding the
private fund’s or a substantially similar
pool of asset’s portfolio holdings or
exposures to an investor that 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.350
Benefits may accrue from these
prohibitions in two situations. First, the
prohibitions may benefit the nonpreferred investors in situations where
advisers lack the ability to commit to
avoid the opportunistic behavior after
entering into the agreement (or
relationship) with the investor. For
example, similar to the case regarding
non-pro rata fee and expense
allocations, an adviser with repeat
business from a large investor with early
redemption rights and smaller investors
with no early redemption rights may
have adverse incentives to take on extra
risk, as the adviser’s preferred investor
could exercise its early redemption
rights to avoid the bulk of losses in the
event an investment begins to fail. The
adviser would then continue to receive
repeat business with the investors with
preferential terms, to the detriment of
the investors with no preferential terms.
Investors who do receive preferential
terms may also receive information over
the course of a fund’s life that the
investors can use to their own gain but
to the detriment of the fund and, by
extension, the other investors. For
instance, if a fund was heavily invested
in a particular sector and an investor
with early redemption rights learned the
sector was expected to suffer
deterioration, that investor could submit
a redemption request, securing their
funds early but forcing the fund to sell
assets in a declining market, harming
the other investors. In this situation, the
prohibitions would provide a solution
to the hold-up problem that is not
currently available. The rule would
benefit the disadvantaged investors by
prohibiting such a situation, and so the
disadvantaged investors would be less
susceptible to hold-up and experience
better performance on their fund
investments as a benefit of the proposed
rule.
Second, in situations where investors
face uncertainty as to whether the
adviser engages in the prohibited
practice, the benefit from the
prohibition would be to eliminate the
costs to investors of avoiding entering
into agreements with advisers that
engage in the practice and the costs to
supra section II.E.
349 Id.
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16951
investors from inadvertently entering
into such agreements.
Specifically, in this second case, the
prohibited preferential terms would
harm investors in private funds and
cause investors to incur extra costs of
researching fund investments to avoid
fund investments in which the
prospective fund adviser engages in
these practices (or costs of otherwise
avoiding or mitigating the harm to those
disadvantaged investors from the
practice). The benefit of the prohibition
to investors would be to eliminate such
costs. It would prohibit disparities in
treatment of different investors in
substantially similar pools of assets in
the case where the disparity is due to
the adviser placing their own interests
ahead of the client’s interests or due to
behavior that may be deceptive.
Investors would benefit from the costs
savings of no longer needing to evaluate
whether the adviser engages in such
practices. Investors and advisers also
may benefit from reduced cost of
negotiating the terms of a fund
investment. Investors who would have
been harmed by the prohibited practices
would benefit from the elimination of
such harms through their prohibition.
The cost of the prohibitions would
depend on the extent to which investors
would otherwise obtain such
preferential terms in their agreements
with advisers and the conditions under
which they make use of the preferential
treatment. Investors who would obtain
and make use of the preferential terms
would incur a cost of losing the
prohibited redemption and information
rights. This would include any investors
who might benefit from the ability to
redeem based on negotiated exceptions
to the private fund’s stated redemption
terms, in addition to the investors who
might benefit from the hold-up
problems discussed above. In addition,
advisers would incur direct costs of
updating their processes for entering
into agreements with investors, to
accommodate what terms could be
effectively offered to all investors once
the option of preferential terms to
certain investors has been removed.
These direct costs may be particularly
high in the short term to the extent that
advisers re-negotiate, re-structure and/or
revise certain existing deals or existing
economic arrangements in response to
this prohibition.
To the extent advisers respond to the
prohibition by developing new
preferential terms and disclosing them
to all investors, there may be new costs
to investors who do not receive these
new preferential terms. As discussed
below, such costs would be mitigated by
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the prohibition of such preferential
terms unless appropriately disclosed.
Prohibition of Other Preferential
Treatment Without Disclosure
The proposed rule also would
prohibit other preferential terms unless
the adviser provides certain written
disclosures to prospective and current
investors, and these disclosures must
contain information regarding all
preferential treatment the adviser
provides to other investors in the same
fund.351 This would reduce the risk of
harm that some investors face from
expected favoritism toward other
investors, and help investors
understand the scope of preferential
terms granted to other investors, which
could help investors shape the terms of
their relationship with the adviser of the
private fund. Because these disclosures
would need to be provided to
prospective investors prior to their
investments and to current investors
annually, these disclosures would help
investors shape the terms of their
relationship with the adviser of the
private fund. This may lead the investor
to request additional information on
other benefits to be obtained, such as coinvestment rights, and would allow an
investor to understand better certain
potential conflicts of interest and the
risk of potential harms or other
disadvantages.
Disclosures of such preferential
treatment would impose direct costs on
advisers to update their contracting and
disclosure practices to bring them into
compliance with the new requirements,
including by incurring costs for legal
services. These direct costs may be
particularly high in the short term to the
extent that advisers re-negotiate, restructure and/or revise certain existing
deals or existing economic arrangements
in response to this prohibition.
However, these costs may also be
reduced by an adviser’s choice between
not providing the preferential terms and
continuing to provide the preferential
terms with the required disclosures, as
the costs to some advisers from not
providing the preferential terms to
investors may be lower than the costs
from the disclosure.
As discussed below, for purposes of
the PRA, we anticipate that the
disclosure of preferential treatment
would impose an aggregate annual
internal cost of $128,902,375 and an
aggregate annual external cost of
$32,550,000, or a total cost of
$161,452,375 annually.352 To the extent
351 See
supra section II.E.
352 See infra section VI.E. As explained in that
section, this estimated annual cost is the sum of the
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that advisers are not prohibited from
categorizing all or a portion of these
costs as expenses to be borne by the
fund, then these costs may be borne
indirectly by investors to the fund
instead of advisers.
To the extent that these disclosures
could discourage advisers from
providing certain preferential terms in
the interest of avoiding future
negotiations with other investors on
similar terms, this prohibition could
ultimately decrease the likelihood that
some investors are granted preferential
terms. As a result, some investors may
find it harder to secure such terms.
4. Audits, Fairness Opinions, and
Documentation of Annual Review of
Compliance Programs
The proposed audit rule would
require an investment adviser that is
registered or required to be registered to
cause each private fund that it advises,
directly or indirectly, to undergo a
financial statement audit that meets
certain elements at least annually and
upon liquidation, if the private fund
does not otherwise undergo such an
audit. These audits would need to be
performed by an independent public
accountant that meets certain standards
of independence and is registered with
and subject to regular inspection by the
PCAOB, and the statements would need
to be prepared in accordance with U.S.
GAAP or, for foreign private funds, must
contain information substantially
similar to statements prepared in
accordance with U.S. GAAP, with
material differences with U.S. GAAP
reconciled.353 The rule would also
require that auditors notify the
Commission in certain circumstances.
In addition, the rule would require
advisers to obtain fairness opinions
from an independent opinion provider
in connection with certain adviser-led
secondary transactions with respect to a
private fund. This requirement would
not apply to advisers that are not
required to register as investment
advisers with the Commission, such as
state-registered advisers and exempt
reporting advisers. In connection with
this fairness opinion, the proposal
would also require a summary of any
material business relationships the
adviser or any of its related persons has,
or has had within the past two years,
with the independent opinion provider.
The proposal would lastly require all
advisers, not just those to private funds,
to document the annual review of their
estimated recurring cost of the proposed rule in
addition to the estimated initial cost annualized
over the first three years.
353 Id.
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compliance policies and procedures in
writing.
We discuss the costs and benefits of
these rule provisions below. The
Commission notes, however, several
factors make the quantification of many
of the economic effects of the proposed
amendments and rules difficult. For
example, there is a lack of quantitative
data on the extent to which adviser-led
secondaries without fairness opinions
differ in fairness of price from adviserled secondaries with fairness opinions
attached. It would also be difficult to
quantify how investors and advisers
may change their preferences over
secondary transactions once fairness
opinions are required to be provided. As
a result, parts of the discussion below
are qualitative in nature.
Benefits
We recognize that many advisers
already provide audited fund financial
statements to fund investors in
connection with the adviser’s
alternative compliance with the custody
rule. However, to the extent that an
adviser does not currently have its
private fund client undergo a financial
statement audit, investors would receive
more reliable information from private
fund advisers as a result of the proposed
audit rule. The benefit to investors in
securitized asset funds may be relatively
greater from the proposal, given the
relatively lower frequency with which
securitized asset funds currently
undergo financial statement audits.354
The audit requirement would provide
an important check on the adviser’s
valuation of private fund assets, which
often serve as the basis for the
calculation of the adviser’s fees. These
audits would likely detect valuation
irregularities or errors, as well as an
investment adviser’s loss,
misappropriation, or misuse of client
investments. It may thereby limit some
opportunities for advisers to materially
over-value investments. Audits provide
substantial benefits to private funds and
their investors because audits also test
other assertions associated with the
investment portfolio (e.g., completeness,
existence, rights and obligations,
presentation). Audits may also provide
a check against adviser
misrepresentations of performance, fees,
and other information about the fund.
Enhanced and standardized regular
auditing may therefore broadly improve
the completeness and accuracy of fund
performance reporting, to the extent
these audits improve fund valuations of
their ongoing investments.
354 See
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Investors who are not currently
provided with audited fund financial
statements, and who would be under
the proposal, may, as a result, have
additional confidence in information
regarding their investments and, in turn,
the fees being paid to advisers. Further,
this additional confidence may facilitate
investors’ capital allocation decisions.
Anticipating a lower risk of harm from
a private fund investment, investors
may be more likely to invest in private
funds and participate in the resulting
returns.
As discussed above, currently not all
financial statement audits are
necessarily conducted by a PCAOBregistered independent public
accountant that is subject to regular
inspection.355 The proposed audit rule’s
requirement that the independent
public accountant performing the audit
be registered with, and subject to regular
inspection by, the PCAOB, is likely to
improve the audit and financial
reporting quality of private funds.356
Higher quality audits generally have a
greater likelihood of detecting material
misstatements due to fraud or error, and
we further believe that investors would
likely have relatively greater confidence
in the quality of audits conducted by an
independent public accountant
registered with, and subject to regular
inspection by, the PCAOB.357 Lastly, we
believe that the proposed audit rule’s
requirement to promptly distribute the
audited financial statements to current
investors would allow investors to
evaluate the audited financial
information in the audit in a timely
manner.
In addition, investors would benefit
from enhanced regulatory oversight as a
result of the requirement for the adviser
to engage the auditor to notify the
Commission under some conditions.358
355 See
supra section V.B.4.
e.g., Daniel Aobdia, The Impact of the
PCAOB Individual Engagement Inspection
Process—Preliminary Evidence, 93 (4) The
Accounting Review 53–80 (2018) (concluding that
‘‘engagement-specific PCAOB inspections influence
non-inspected engagements, with spillover effects
detected at both partner and office levels’’ and that
‘‘the information communicated by the PCAOB to
audit firms is applicable to non-inspected
engagements’’); Daniel Aobdia, The Economic
Consequences of Audit Firms’ Quality Control
System Deficiencies, 66 (7) Management Science
(July 2020) (concluding that ‘‘common issues
identified in PCAOB inspections of individual
engagements can be generalized to the entire firm,
despite the PCAOB claiming that its engagement
selection process targets higher-risk clients’’ and
that ‘‘[PCAOB quality control] remediation also
appears to positively influence audit quality’’).
357 Id.
358 This requirement does not exist under the
custody rule, and as a result, the benefits and costs
associated with this requirement would extend to
even those investors and funds for which advisers
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The proposed requirement for the
auditor to report terminations and
modified opinions privately to the SEC
would enable the SEC to receive more
timely, complete, and independent
information in these circumstances and
to evaluate the need for an examination
of the adviser. As a result, the SEC
would be able to allocate its resources
more efficiently. This could lead to a
higher rate of detection of fund adviser
activities that lead to harms from
misstatements and a greater potential for
mitigation of such harms. Anticipating
this, fund advisers would have stronger
incentives to avoid such harmful
activities.
The proposal’s requirement that an
adviser distribute a fairness opinion and
summary of material business
relationships with the opinion provider
in connection with certain adviser-led
secondary transactions may provide
similar increases in investor confidence
in the specific context of adviser-led
secondary transactions. This
requirement would provide an
important check against an adviser’s
conflicts of interest in structuring and
leading these transactions. Investors
would have decreased risk of
experiencing harm from mis-valuation
of secondary-led transactions. Further,
anticipating a lower risk of harm from
mis-valuation when participating in
such transactions, investors may be
more likely to participate. The result
may be a closer alignment between
investor choices and investor
preferences over private fund terms,
investment strategies, and investment
outcomes. These benefits would,
however, be reduced to the extent that
advisers are already obtaining fairness
opinions as a matter of best practice.
Finally, this proposed rule
amendment would require all SECregistered advisers to document the
annual review of their compliance
policies and procedures in writing. This
would allow our staff to better
determine whether an adviser has
complied with the review requirement
of the compliance rule, and would
facilitate remediation of noncompliance. Because our staff’s
determination of whether the adviser
has complied with the compliance rule
will become more effective, the rule
may reduce the risk of non-compliance,
as well as any risk to investors
associated with non-compliance.
These benefits from mandatory audits
and fairness opinions are particularly
relevant for illiquid investments.
Illiquid assets currently are where we
are already distributing audits under the custody
rule.
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believe it is most feasible for financial
information to have material
misstatements of investment values, for
adviser-led secondary transactions to
occur at unfair prices, and where there
is broadly a higher risk of investor harm
from potential conflicts of interest or
fraud. This is because currently, as
discussed above, advisers may use a
high level of discretion and subjectivity
in valuing a private fund’s illiquid
investments, and the adviser further
may have incentives to bias the fair
value estimates of the investment
upwards in order to generate larger
fees.359 Because both funds determined
to be liquid funds and illiquid funds
may have illiquid investments, investors
in both types of funds will benefit,
though the benefits may be larger for
investors in illiquid funds (as such
funds may have more illiquid
investments than liquid funds and are
more likely to have adviser-led
secondary transactions). The benefits
from documentation of compliance
programs will be relevant for all
investors, as the rule applies to all fund
advisers, not just private fund advisers.
Costs
As discussed above, we recognize that
many advisers already provide audited
financial statements to fund investors in
connection with the adviser’s
alternative compliance with the custody
rule.360 To the extent that an adviser
does not currently have its private fund
client undergo the required financial
statement audit, there would be direct
costs of obtaining the auditor, providing
the auditor with resources needed to
conduct the audit, the audit fees, and
promptly distributing the audit results
to current investors. We recognize that
the proposed audit rule’s requirement to
promptly distribute the audited
financial statements to current investors
after the audit’s completion may also
impose compliance costs, which would
be mitigated by the flexibility of the
proposal’s requirement for prompt
distribution, relative to a requirement
for distribution to occur by a a specific
deadline. Under current practice, the
costs of undergoing a financial
statement audit are often paid by the
fund, and therefore, ultimately, by the
fund investors, though in some cases the
costs may be partially or fully paid by
the adviser. To the extent not
prohibited, we expect similar
arrangements may be made going
forward to comply with the proposed
rule: In some instances, the fund will
bear the audit expense, in others the
359 See
360 See
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adviser will bear it, and there also may
be arrangements in which both the
adviser and fund will share the
expense.361 Advisers could alternatively
attempt to introduce substitute charges
(for example, increased management
fees) in order to cover the costs of
compliance with the rule, but their
ability to do so may depend on the
willingness of investors to incur those
substitute charges.
As discussed below, based on Form
ADV filings, as of November 30, 2021,
there were 5,037 registered advisers
providing advice to private funds, and
we estimate that these advisers would,
on average, each provide advice to 9
private funds.362 We further estimate
that the audit fee for the required
private fund audit would be $60,000 per
fund on average.363 For purposes of the
PRA, the estimated total auditing fees
for all funds would therefore be
approximately $2,720 million
annually.364 We further anticipate that
the audit requirement would impose for
all funds approximately 92,479.32 hours
of internal annual burden hours and a
cost of approximately $27.6 million for
internal time.365 However, some funds
would obtain the required financial
statement audits in the absence of the
proposal. The cost of the proposed audit
requirement would therefore depend on
the extent to which funds currently
receive audits and, if so, whether their
auditors are registered with the PCAOB.
For example, all or a portion of the
costs described in this section may be
disproportionately borne by advisers or
investors (or both) to securitized asset
funds,366 given that fewer securitized
asset funds currently undergo financial
statement audits than other categories of
funds.367 We believe that the costs
incurred may approximate 10% of these
amounts, because across all types of
funds, approximately 90% of funds are
currently audited in connection with
the fund adviser’s alternative
compliance under the custody rule.368
However, because a large portion of
361 See
infra section VI.C.
infra section VI.C.
363 See infra footnote 420. The audit fee for an
individual fund may be higher or lower than this
estimate, with individual fund audit fees varying
according to fund characteristics, such as the
jurisdiction of the assets, complexity of the
holdings, the firm providing the services, and
economies of scales.
364 See infra section VI.C.
365 Id.
366 As noted above, to the extent not prohibited,
we expect that in some instances, the fund will bear
the audit expense, in others the adviser will bear
it, and there also may be arrangements in which
both the adviser and fund will share the expense.
367 See supra section V.B.4.
368 Id.
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funds who do not currently undergo
financial statement audits are
securitized asset funds, to the extent
that audits for securitized asset funds
are more costly than for other fund
types (for example, if it is more
burdensome to audit financial
statements that primarily contain
securitized assets), then the costs of the
proposal may be greater than 10% of the
amounts described above.
For advisers that had been complying
with the surprise examination
requirement of the custody rule and do
not have other clients (e.g., separately
managed accounts) for which a surprise
exam must be obtained, the costs of the
audit performed in accordance with the
proposed audit rule would be offset by
the reduction in costs from no longer
obtaining a surprise examination. To the
extent that audits cost more than
surprise examinations, the offset may be
only partial, and to the extent that an
adviser must continue to undergo a
surprise examination because it has
custody of non-private fund client funds
and securities, there likely would be no
offset. For funds that had received an
audit by an auditor that is not registered
with the PCAOB, the costs of the audit
performed in accordance with the
proposed audit rule would also be offset
by the reduction in costs from no longer
obtaining their previous audit, although
we anticipate that the cost of the
required audit would likely be greater
because a PCAOB-registered and
-inspected auditor may cost more than
an auditor that is not subject to the same
level of PCAOB oversight.
We also understand that the PCAOB
registration and inspection requirement
may limit the pool of auditors that are
eligible to perform these services which
could, in turn, increase costs, as a result
of the potential for these auditors to
charge higher prices for their services.
The increase in demand for these
services, however, may be limited in
light of the high percentage of funds
already being audited.369 The
Commission notification requirement of
the proposed audit rule would represent
a new cost, regardless of whether their
private fund clients are already
undergoing a financial statement audit.
We anticipate that accounting firms
would increase their fees as a result of
this new obligation and perceived
liability. For advisers who had been
undergoing a surprise examination for
purposes of the custody rule, there may
not be as great of an increase in costs in
light of similar requirements in
369 Id.
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connection with those examinations
under that rule.
The indirect costs of the independent
audit requirement would depend on the
quality of the financial statements of the
funds newly subject to audits. These
costs may be relatively higher for the
funds with lower quality financial
statements (i.e., the funds with the
greatest benefit from the audit
requirement). The indirect costs from
the independent audit requirement may
include costs of changing the fund’s
internal financial reporting practices,
such as improvements to internal
controls over financial reporting, to
avoid potential harm to investors from
a misstatement. Further, we understand
that the requirement to have the auditor
registered with, and subject to the
regular inspection by, the PCAOB may
limit the pool of accountants that are
eligible to perform these services
because only those accountants that
conduct public company issuer audits
are subject to regular inspection by the
PCAOB.370 The resulting competition
for these services might generally lead
to an increase in their costs, as an effect
of the proposal.
Costs would also be incurred related
to obtaining the required fairness
opinion and material business
relationship summary in the case of an
adviser-led secondary transaction. For
purposes of the PRA, we estimate that
10% of advisers providing advice to
private funds conduct an adviser-led
secondary transaction each year and
that the funds would pay external costs
of $40,849 for each fairness opinion and
material business relationship
summary.371 Because only
approximately 10 percent of advisers
conduct an adviser-led secondary
transaction each year, the estimated
total fees for all funds per year would
therefore be approximately $20.6
million.372 Further, as discussed in
section VI.D below, we anticipate that
the fairness opinion and material
business relationship summary
requirements would impose
approximately 3,528 hours of internal
370 The Sarbanes-Oxley Act authorizes the
PCAOB to inspect registered firms for the purpose
of assessing compliance with certain laws, rules,
and professional standards in connection with a
firm’s audit work for public company and brokerdealer clients. However, the PCAOB currently has
only a temporary inspection program for brokerdealer clients.
371 See infra section VI.D; footnote 430. The
fairness opinion fee for an individual fund may be
higher or lower than this estimate, with individual
fund audit fees varying according to the complexity,
terms, and size of the adviser-led secondary
transaction, as well as the nature of the assets of the
fund.
372 See supra section II.C; see also infra section
VI.D.
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annual burden hours and a cost of
approximately $1,219,499 for internal
time annually.373 These costs will be
borne primarily, though not exclusively,
by closed-end funds determined to be
illiquid funds,374 as these are the funds
that most frequently have the adviserled secondaries considered by the rule.
To the extent that certain hedge fund
transactions are captured by the rule,
these funds and their investors would
also face comparable fees and costs.
The costs associated with obtaining
fairness opinions could dissuade some
private fund advisers from leading these
transactions, which could decrease
liquidity opportunities for some private
fund advisers. Under current practice,
some investors bear the expense
associated with obtaining a fairness
opinion if there is one. To the extent not
prohibited, we expect similar
arrangements may be made going
forward to comply with the proposed
rule. Advisers could alternatively
attempt to introduce substitute charges
(for example, increased management
fees) in order to cover the costs of
compliance with the rule, but their
ability to do so may depend on the
willingness of investors to incur those
substitute charges.
In addition, the required
documentation of the annual review of
the fund compliance program has direct
costs that include the cost of legal
services associated with the preparation
of such documentation. As discussed
below, for purposes of the PRA, we
anticipate that the requirement for all
SEC-registered advisers to document the
annual review of their compliance
policies and procedures in writing
would, for all advisers, impose 44,496
hours of internal annual burden hours at
a cost of approximately $18.9 million
for internal time, and approximately
$4.1 million for external costs.375
5. Recordkeeping
Finally, the proposed amendment to
the recordkeeping rule would require
advisers who are registered or required
to be registered to retain books and
records related to the proposed
quarterly statement rule,376 to retain
books and records related to the
mandatory adviser audit rule,377 to
support their compliance with the
proposed adviser-led secondaries
rule,378 and to support their compliance
with the proposed preferential treatment
373 See
infra section VI.D.
supra section II.C.
375 See infra section VI.F.
376 See supra section II.A.5.
377 See supra section II.B.8.
378 See supra section II.C.1.
374 See
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disclosure rule.379 The benefit to
investors would be to enable an
examiner to verify more easily that a
fund is in compliance with these
proposed rules and to facilitate the more
timely detection and remediation of
non-compliance. These requirements
would also help facilitate the
Commission’s enforcement and
examination capabilities. Also
beneficial to investors, advisers may
react to the enhanced ability of third
parties to detect and impose sanctions
against non-compliance due to the
recordkeeping requirements by taking
more care to comply with the substance
of the rule.
These requirements would impose
costs on advisers related to maintaining
these records. As discussed below, for
purposes of the PRA, we anticipate that
the additional recordkeeping obligations
would impose, for all advisers, 40,800
hours of internal annual burden hours
and that the annual cost would be
approximately $2.8 million.380
D. Effects on Efficiency, Competition,
and Capital Formation
1. Efficiency
The proposed rules would likely
enhance economic efficiency by
enabling investors more easily to
identify funds that align with their
preferences over private fund terms,
investment strategies, and investment
outcomes, and also by causing fund
advisers to align their actions more
closely with the interests of investors
through the elimination of prohibited
practices.
First, the proposed rules could
increase the usefulness of the
information that investors receive from
private fund advisers regarding the fees,
expenses, and performance of the fund,
and regarding the preferential treatment
of certain investors of the fund through
the more detailed and standardized
disclosures discussed above.381 These
enhanced disclosures would provide
more information to investors regarding
the ability and potential fit of
investment advisers, which may
improve the quality of the matches that
investors make with private funds and
investment advisers in terms of fit with
investor preferences over private fund
terms, investment strategies, and
investment outcomes. The enhanced
disclosures may also reduce search
costs, as investors may be better able to
evaluate the funds of an investment
adviser based on the information to be
supra section II.E.1.
infra section VI.G.
381 See supra section V.C.2, V.C.3.
disclosed at the time of the investment
and in the quarterly statement.
Regarding preferential treatment, the
proposed rules further align fund
adviser actions and investor interests by
prohibiting certain preferential
treatment practices altogether (instead
of only requiring disclosure),
specifically prohibiting preferential
terms regarding liquidity or
transparency that have a material,
negative impact on investors in the fund
or a substantially similar pool of
assets.382 Prohibiting these activities,
and prohibiting remaining preferential
treatment activities unless disclosure is
provided, may eliminate some of the
complexity and uncertainty that
investors face about the outcomes of
their investment choices, further
reducing costs investors must undertake
to find appropriate matches between
their choice of private fund and their
preferences over private fund terms,
investment strategies, and investment
outcomes.
In addition, the proposed rules’
requirements for advisers to obtain
audits of fund financial statements
would enhance investor protection and
thereby improve the efficiency of the
investment adviser search process.
While many proposed disclosure
requirements involve disclosures only
to current investors, and not prospective
investors, the proposed rule’s disclosure
requirements may enhance efficiency
through the tendency of some fund
advisers to rely on investors in current
funds to be prospective investors in
their future funds. For example, when
fund advisers raise multiple funds
sequentially, current investors can base
their decisions on whether to invest in
subsequent funds based on the
disclosures of the prior funds.383 As
such, improved disclosures can improve
the efficiency of investments without
directly requiring disclosures to all
prospective investors. Investors may
therefore face a lower overall cost of
searching for, and choosing among,
alternative private fund investments.
Lastly, the proposed rules prohibit
various activities that represent possible
conflicting arrangements between
investors and fund advisers. To the
extent that investors currently bear costs
of searching for fund advisers who do
not engage in these arrangements, or
bear costs associated with monitoring
fund adviser conduct to avoid harm,
then prohibiting these activities may
lower investors’ overall costs of
searching for, monitoring, and choosing
among alternative private fund
379 See
380 See
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383 See
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investments. This may particularly be
the case for smaller investors who are
currently more frequently harmed by
the activities being considered.
There may be losses of efficiency from
the proposed rules to prohibit various
activities, and from any changes in fund
practices in response to the proposed
rules, to the extent that investors
currently benefit from those activities or
incur costs from those changes. For
example, investors who currently
receive preferential terms that would be
prohibited under the proposal may have
only invested with their current adviser
because they were able to secure
preferential terms. With those
preferential terms removed, those
investors may choose to re-evaluate the
match between their choice of adviser
and their overall preferences over
private fund terms, investment strategy,
and investment outcomes. Depending
on the results of this re-evaluation,
those investors may choose to incur
costs of searching for new fund advisers
or alternative investments.
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2. Competition
The proposed rules may also affect
competition in the market for private
fund investing. As discussed above,
private fund adviser fees may currently
total in the hundreds of billions of
dollars per year.384 Enhanced
competition from additional
transparency may lead to lower fees or
may direct investor assets to different
funds, fund advisers, or other
investments.
First, to the extent that the enhanced
transparency of certain fees, expenses,
and performance of private funds under
the proposal may reduce the cost to
some investors of comparing private
fund investments, then current investors
evaluating whether to continue
investing in subsequent funds may be
more likely to reject future funds raised
by their current adviser in favor of the
terms of competing funds, including
new funds that advisers may offer as
alternatives that they would not have
offered absent the increased
transparency.
To the extent that this heightened
transparency encourages advisers to
make more substantial disclosures to
prospective investors, investors may
also be able to obtain more detailed fee
and expense and performance data for
other prospective fund investments,
strengthening the effect of the proposal
on competition.385 Advisers may
therefore update the terms that they
offer to investors, or investors may shift
their assets to different funds.
Second, because enhanced
transparency of preferential treatment
will be provided to both current and
prospective investors, there may be
reduced search costs to all investors
seeking to compare funds on the basis
of which investors receive preferential
treatment. For example, some funds
may lose investors who only
participated in the fund because of the
preferential terms they received. We
anticipate that investors withdrawing
from a fund because of a loss of
preferential treatment would redeploy
their capital elsewhere, and so new
advisers would have a new pool of
investment capital to pursue.
3. Capital Formation
We believe the proposed rules would
facilitate capital formation by causing
advisers to more efficiently manage
private fund clients, by prohibiting
activities that may currently deter
investors from private fund investing
because they represent possible
conflicting arrangements, and by
enabling investors to choose more
efficiently among funds and fund
advisers. This may reduce the cost of
intermediation between investors and
portfolio investments. To the extent this
occurs, this would lead to enhanced
capital formation in the real economy,
as portfolio companies would have
greater access to the supply of financing
from private fund investors. This would
contribute to greater capital formation
through greater investment into those
portfolio companies.
The proposed rules may also enhance
capital formation through their
competitive effects by inducing new
fund advisers to enter private fund
markets.386 To the extent that existing
fund advisers reduce their fees in order
to compete more effectively, or to the
extent that existing pools of capital are
redirected to fund advisers who
generate enhanced returns for their
investors (for example, advisers who
generate larger returns, less correlated
returns across different investment
strategies, or returns with more
favorable risk profiles), the competitive
effects of the proposal may provide new
opportunities for capital allocation and
potentially spur new investments.
Similarly, and in addition to lower
costs of intermediation between
investors and portfolio investments, the
proposed rules may directly lower the
costs charged by fund advisers to
investors by improving transparency
over fees and expenses. The proposed
384 Id.
385 See
supra section V.C.2.
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rules may also enhance overall investor
returns (for example, as above, larger
returns, less correlated returns across
different investment strategies, or
returns with more favorable risk
profiles) by improving transparency
over performance information,
prohibiting conflicting arrangements,
and requiring external financial
statement audits and fairness opinions.
To the extent these increased investor
funds from lower expenses and
enhanced returns are redeployed to new
investments, there would be further
benefits to capital formation.
There may be reduced capital
formation associated with the proposed
rules to prohibit various activities, to
the extent that investors currently
benefit from those activities. For
example, investors who currently
receive preferential terms that would be
prohibited under the proposal may
withdraw their capital from their
existing fund advisers. Those investors
may have less total capital to deploy
after bearing costs of searching for new
investment opportunities, or they may
redeploy their capital away from private
funds more broadly and into
investments with less effective capital
formation.
E. Alternatives Considered
1. Alternatives to the Requirement for
Private Fund Advisers To Obtain an
Annual Audit
First, the Commission could consider
broadening the application of this rule
to, for example, apply to all advisers to
private funds, rather than to only
advisers to private funds that are
registered or required to be registered.
Extending the application of the
proposed audit rule to all advisers and
in the context of these pooled
investment vehicles would increase the
benefits of helping investors receive
more reliable information from private
fund advisers associated with the rule.
Investors would, as a result, have greater
assurance in both the valuation of fund
assets and, because these valuations
often serve as the basis for the
calculation of the adviser’s fees, the fees
charged by advisers. However, the
extension of the proposed rule to apply
to all advisers would likely impose the
costs of obtaining audits on smaller
funds advised by unregistered advisers.
For these types of funds, the cost of
obtaining such an audit may be large
compared to the value of fund assets
and fees and the related value to
investors of the required audit, and so
this alternative could inhibit entry of
new funds, potentially constraining the
growth of the private fund market.
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Second, instead of broadening the
proposed audit rule, we could consider
narrowing the rule by providing full or
partial exemptions. For example, we
could exempt smaller funds or we could
exempt an adviser from compliance
with the rule where an adviser plays no
role in valuing the fund’s assets,
receives little or no compensation for its
services, or receives no compensation
based on the value of the fund’s assets.
We could also exempt advisers of hedge
funds and other funds determined to be
liquid funds. Further, we could provide
an exemption for private funds below a
certain asset threshold, for funds that
have only related person investors, or
for funds that are below a minimum
asset value or have a limited number of
investors.
These exemptions could also be
applied in tandem, for example by
exempting only advisers to hedge funds
and other funds determined to be liquid
funds below a certain asset threshold.
For each of these categories, we could
consider partial instead of full
exemptions, for example by requiring an
audit only every two (or more) years
instead of not requiring any annual
audits at all. Further, the benefits of the
rule may not be substantial for funds
below a minimum asset value, where
the cost of obtaining such an audit
would be relatively large compared to
the value of fund assets and fees that the
rule is intended to provide a check on.
We believe, however, that this
narrower alternative with the above
exemptions to the proposed audit rule
would likely not provide the same
investor protection benefits. Many of the
investor protection benefits discussed
above are specifically associated with
the general applicability of the proposed
audit rule.387
Finally, instead of requiring an audit
as described in the proposed audit rule,
we could consider requiring that
advisers provide other means of
checking the adviser’s valuation of
private fund assets. For example, we
could consider requiring that an adviser
subject to the proposed audit rule
provide information to substantiate the
adviser’s evaluation to its LPAC or, if
the fund has no LPAC, then to all, or
only significant investors in the fund.
We believe that such methods for
checking an adviser’s methods of
valuation would be substantially less
expensive to obtain, which could reduce
the cost burdens associated with an
audit.
However, we believe that these
alternatives would likely not
accomplish the same investor protection
387 See
supra section V.C.4.
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benefits as the proposal to require an
audit. As an immediate matter, limiting
the requirement like so would
undermine the broader goal of the
proposal to standardize information
made available to different investors.
We believe, more generally, that these
checks would not provide the same
level of assurance over valuation and,
by extension, fees, to fund investors as
an audit. As discussed above, we have
historically relied on financial statement
audits to verify the existence of pooled
investment vehicle investments.
2. Alternatives to the Requirement To
Distribute a Quarterly Statement to
Investors Disclosing Certain Information
Regarding Costs and Performance
The Commission could also consider
requiring that additional and more
granular information be provided in the
quarterly statements that we are
proposing be sent by registered
investment advisers to investors in
private funds. For example, we could
require that these statements include
investor-level capital account
information, which would provide each
investor with means of monitoring
capital account levels at regular
intervals throughout the year. Because
this more specific information would
show exactly how fees, expenses, and
performance have affected the investor,
it could, effectively, further reduce the
cost to an investor of monitoring the
value of the services the adviser
provides to the investor. We believe,
however, that requiring capital account
information for each investor would
substantially increase costs for funds
associated with the preparation of these
quarterly statements.
We could also, for example, require
disclosure of performance information
for each portfolio investment. For funds
determined to be illiquid funds in
particular, we could require advisers to
report the IRR for portfolio investments,
assuming no leverage, as well as the
cash flows for each portfolio
investment.388 Given the cash flows,
end investors could compute other
performance metrics, such as PME, for
themselves. In addition, this
information would give investors means
388 For funds determined to be liquid funds,
disclosure of performance information for each
portfolio investment may be of comparatively lower
incremental benefit to investors, because such
funds typically have a much larger number of
investments. To the extent that investors’
preferences over different liquid funds depend on
more fund outcomes than their total return on their
aggregate capital contributions, for example a
preference for fund advisers with uncorrelated
returns across different portfolio investments, then
this alternative could provide similar additional
benefits.
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of checking the more general
performance information provided in a
quarterly statement, and would, further,
allow investors to track and evaluate the
portfolio investments chosen by an
adviser over time. Cash flow disclosures
for each portfolio investment would
enable an investor to construct measures
of performance that address the MOIC’s
inability to capture the timing of cash
flows, avoid the IRR’s assumptions on
reinvestment rates of early cash flow
distributions, and avoid the IRR’s
sensitivity to cash flows early in the life
of the pool.389 Investors would also be
able to compare performance of
individual portfolio investments against
the compensation and ownership
percentage and other data that advisers
would be required to disclose for each
portfolio investment under the
proposal.390
While we believe that advisers would
have cash flow data for each portfolio
investment available in connection with
the preparation of the standardized fund
performance information required to be
reported pursuant to the proposed rule,
calculating performance information for
each portfolio investment in accordance
with the rule could add significant
operational burdens and costs, which
would vary depending on factors that
include the number of portfolio
investments held by a private fund. The
operational burden and cost would also
depend on whether the alternative
proposal required both gross and net
performance information for each
portfolio investment, which would
determine whether the information
reflected the impact of fund-level fees
and expenses on the performance of
each portfolio investment. Requiring
both gross and net performance
information for each portfolio
investment would be of greater use to
investors, but would come at a higher
operational burden and cost, as
providing net performance information
would require more complex
calculations to allocate fund fees and
expenses across portfolio investments.
Lastly, to the extent that advisers were
required to disclose cash flows for each
portfolio investment without the impact
of fund-level subscription facilities, this
calculation may be more burdensome
than the single calculation required to
389 See supra section V.B.3. See, e.g., Robert
Harris, Tim Jenkinson and Steven Kaplan, Private
Equity Performance: What Do We Know?, 69 (5)
Journal of Finance 1851 (Mar. 27, 2014), available
at https://onlinelibrary.wiley.com/doi/full/10.1111/
jofi.12154; Steven Kaplan and Antoinette Schoar,
Private Equity Performance: Returns, Persistence,
and Capital Flows, 60 (5) Journal of Finance (Aug.
2005), available at https://web.mit.edu/aschoar/
www/KaplanSchoar2005.pdf.
390 See supra section II.A.1.b.
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make the required fund-level
performance information disclosures
without the impact of fund-level
subscription facilities.
As a final granular addition to
performance disclosures, the
Commission could require the reporting
of a wider variety of performance
metrics for hedge funds and other funds
determined to be liquid funds, similar to
the detailed disclosure requirements for
funds determined to be illiquid funds.
These could include requirements for
funds determined to be liquid funds to
report estimates of fund-level alphas,
betas, Sharpe ratios, or other
performance metrics. We believe that for
investors of funds determined to be
liquid funds, absolute returns are of
highest priority, and furthermore
investors may calculate many of these
additional performance metrics
themselves by combining fund annual
total returns with publicly available
data. Therefore, we believe these
additional reporting requirements
would impose additional costs with
comparatively little benefit.
Further, the Commission could also
consider requiring less information be
provided to investors in these quarterly
statements. For example, instead of
requiring the disclosure of
comprehensive fee and expense
information, we could require that
advisers disclose only a subset of these,
including investments fees and
expenses paid by a portfolio company to
the adviser. These fees in particular may
currently present the biggest burden on
investors to track, and requiring the
disclosure of only these fees could
reduce some costs associated with the
effort of compiling, on a quarterly basis,
information regarding management fees
more generally. We believe, however,
that if we did not require
comprehensive information, investors
would not derive the same utility in
monitoring fund performance.
We could also consider requiring that
comprehensive information regarding
fees and performance be reported on
Form ADV, instead of being disclosed to
investors individually. Reporting
publicly on Form ADV would continue
to allow investors to monitor
performance, while also allowing public
review of important information about
an adviser. However, because the
information we propose to require
under the rule is tailored to what we
believe would serve existing investors
in a fund, we believe that direct delivery
to investors would better reduce
monitoring costs for investors. Further,
as discussed above, prospective
investors have separate protections,
including against misleading, deceptive,
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and confusing information in
advertisements as set forth in the
recently adopted marketing rule.391
Instead of requiring disclosure of
comprehensive fee and expense
information to investors, we could
consider prohibiting certain fee and
expense practices. For example, we
could prohibit charging fees at the fund
level in excess of a certain maximum
amount that we could determine to be
what investors could reasonably
anticipate being charged by an adviser.
This could, effectively, protect investors
from unanticipated charges, and reduce
monitoring costs to investors. Further,
we could prohibit certain compensation
arrangements, such as the ‘‘2 and 20’’
model or compensation from portfolio
investments, to the extent the adviser
also receives management fees from the
fund. Prohibition of the ‘‘2 and 20’’
model would cause investors to
reallocate their capital way from funds
that employ this model and toward
other types of funds. It may cause
advisers to consider and adopt more
efficient models for private fund
investing in which the adviser gets a
smaller fee and the investor gets a larger
share of the gross fund returns, and in
which investors are generally better
off.392 We could also consider
restricting management fee practices, for
example by imposing limitations on
sizes of management fees, or
requirement management fees to be
based on invested capital or net asset
value rather than on committed capital.
However, the benefits of prohibiting
certain fee and expense practices
outright would need to be balanced
against the costs associated with
limiting an adviser and investor’s
flexibility in designing fee and expense
arrangements tailored to their
preferences. We believe that any such
prohibitions would, accordingly, need
to be carefully tailored.
Similarly, instead of requiring
disclosure of comprehensive
performance information to investors,
we could consider prohibiting certain
performance disclosure practices. For
example, instead of requiring disclosure
of performance without the effect of
fund-level subscription facilities, we
could consider prohibiting advisers
from presenting performance with the
391 See
supra section II.A.2.
example, the compensation model for
hedge funds can provide fund advisers with
embedded leverage, encouraging greater risk-taking.
See, e.g., Alon Brav, Wei Jiang, and Rongchen Li,
Governance by Persuasion: Hedge Fund Activism
and Market-Based Shareholder Influence, European
Corporate Governance Institute—Finance (Working
Paper No. 797/2021), available at https://ssrn.com/
abstract=3955116 or https://dx.doi.org/10.2139/
ssrn.3955116.
392 For
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effect of such facilities. Similarly, we
could consider prohibiting advisers
from presenting combined performance
information for multiple funds, such as
a main fund and a co-investment fund
that pays lower or no fees. We believe
that the required disclosures present the
correct standardized, detailed
information for investors to be able to
evaluate performance, but we do not
believe there are harms from advisers
electing to disclose additional
information. As such, we think the
benefits of prohibiting any performance
disclosure practices would likely be
negligible, while there could be
substantial costs to investors who value
the information that would be
prohibited under this alternative.
Finally, the Commission could
consider broadening the application of
this rule to, for example, apply to all
advisers to private funds, rather than to
only advisers to private funds that are
registered or required to be registered.
Extending the application of the
proposed rule to all advisers would
increase the benefits of helping
investors receive more detailed and
standardized information regarding fees,
expenses, and performance. Investors
would, as a result, have better
information with which to evaluate the
services of these advisers. It is, however,
not clear to us that these benefits would
also be realized in contexts where fund
performance is not as heavily relied
upon when obtaining new investors, as
is the case for private funds. Further, the
extension of the proposed rule to apply
to all advisers would likely impose the
costs of compiling, preparing, and
distributing quarterly statements on
smaller funds advised by unregistered
advisers. For these types of funds, these
quarterly statement costs may be large
compared to the value of fund assets
and fees and the related value to
investors of the required audit.
3. Alternative to the Required Manner of
Preparing and Distributing Quarterly
Statements and Audited Financial
Statements
The proposed rules would require
private fund advisers to ‘‘distribute’’
quarterly statements and audited annual
financial statements to investors in the
private fund, and this requirement
could be satisfied through either paper
or electronic means.393 The Commission
could consider requiring private fund
advisers to prepare and distribute the
required disclosures electronically using
a structured data language, such as the
393 See
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Inline eXtensible Business Reporting
Language (‘‘Inline XBRL’’).
An Inline XBRL requirement for the
disclosures could benefit private fund
investors with access to XBRL analysis
software by enabling them to more
efficiently access, compile, and analyze
the disclosures in quarterly statements
and audited annual financial
statements, facilitating calculations and
comparisons of the disclosed
information across different time
periods or across different portfolio
investments within the same time
period. For any such private fund
investors who receive disclosures from
multiple private funds, an Inline XBRL
requirement could also facilitate
comparisons of the disclosed
information across those funds.
An Inline XBRL requirement for the
proposed disclosures would diverge
from the Commission’s other Inline
XBRL requirements, which apply to
disclosures that are made available to
the public and the Commission, thus
allowing for the realization of
informational benefits (such as
increased market efficiency and
decreased information asymmetry)
through the processing of Inline XBRL
disclosures by information
intermediaries such as analysts and
researchers.394 Under the current
proposal, the required disclosures
would not be provided to the public or
the Commission for processing and
analysis. Thus, the magnitude of benefit
resulting from an Inline XBRL
alternative for the disclosure
requirements in this proposal may be
lower than for other rules with Inline
XBRL requirements.395
Compared to the proposal, an Inline
XBRL requirement would result in
additional compliance costs for private
394 See, e.g., Y. Cong, J. Hao, and L. Zou, The
Impact of XBRL Reporting on Market Efficiency, 28
J. Info. Sys. 181 (2014) (finding support for the
hypothesis that ‘‘XBRL reporting facilitates the
generation and infusion of idiosyncratic
information into the market and thus improves
market efficiency’’); Y. Huang, J.T. Parwada, Y.G.
Shan, and J. Yang, Insider Profitability and Public
Information: Evidence From the XBRL Mandate
(Working Paper, 2019) (finding XBRL adoption
levels the informational playing field between
insiders and non-insiders).
395 See, e.g., Updated Disclosure Requirements
and Summary Prospectus for Variable Annuity and
Variable Life Insurance Contracts, Release No. IC–
33814 (Mar. 11, 2020) [85 FR 25964 at 26041 (Jun.
10, 2020)] (Noting that an Inline XBRL requirement
for certain variable contract prospectus disclosures,
which are publicly available, would include
informational benefits stemming from use of the
Inline XBRL data by parties other than investors,
including financial analysts, data aggregators, and
Commission staff. While the required disclosures in
this proposal would not be provided to the public
or the Commission, such benefits would not accrue
from an Inline XBRL requirement for the required
disclosures).
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funds and advisers, as a result of the
requirement to select, apply, and review
the appropriate XBRL U.S. GAAP
taxonomy element tags for the required
disclosures (or pay a third-party service
provider to do so on their behalf). In
addition, private fund advisers may not
have prior experience with preparing
Inline XBRL documents, as neither
Form PF nor Form ADV is filed using
Inline XBRL. Thus, under this
alternative, private funds may incur the
initial Inline XBRL implementation
costs that are often associated with
being subject to an Inline XBRL
requirement for the first time (including,
as applicable, the cost of training inhouse staff to prepare filings in Inline
XBRL and the cost to license Inline
XBRL filing preparation software from
vendors). Accordingly, the magnitude of
compliance cost resulting from an Inline
XBRL requirement under this proposal
may be higher than for other rules with
Inline XBRL requirements.
4. Alternatives to the Prohibitions From
Engaging in Certain Sales Practices,
Conflicts of Interest, and Compensation
Schemes
The Commission could also consider
prohibiting other activities, in addition
to those currently prohibited in the
proposed rule. For example, we could
prohibit advisers from charging private
funds for expenses generally understood
to be adviser expenses, such as those
incurred in connection with the
maintenance and operation of the
adviser’s business. To the extent that the
performance of these activities is
outsourced to a consultant, for example,
and the fund is charged for that service,
advisers may be effectively shifting
expenses that would be generally
recognized as adviser expenses to
instead be fund expenses. The
prohibition of such charges could
reduce investor monitoring costs. We
believe, however, that identifying the
types of charges associated with
activities that should never be charged
to the fund would likely be difficult. As
a result, any such prohibition could risk
effectively limiting an adviser’s ability
to outsource certain activities that could
be better performed by a consultant,
because under the prohibition the
adviser would not be able to pass those
costs on to the fund.
Further, the Commission could
consider providing an exemption for
funds utilizing a pass-through expense
model from the prohibition on charging
fees or expenses associated with certain
examinations, investigations, and
regulatory and compliance fees and
expenses. This would allow advisers to
avoid the costs associated with re-
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structuring any arrangements not
compliant with the prohibition, given
the proposed rules would likely prohibit
certain aspects of these expense
models.396 We believe, however, that
any exemption would need to be
carefully balanced against the risk that
it would continue to subject the fund to
an adviser’s incentive to shift its fees
and expenses to the fund to reduce its
overhead and operating costs.
We could also consider requiring
detailed and standardized disclosures of
the activities under consideration,
instead of prohibiting the activities
outright. This alternative may be
desirable to the extent that certain
investors would be willing to bear the
costs of these activities in exchange for
certain other beneficial terms, and
would be willing to give informed
consent to fund advisers engaging in the
practices under consideration. However,
we do not believe that disclosure
requirements would achieve the same
benefit of protecting investors from
harm, because many of the practices are
deceptive and result in obscured
payments, and so may be used to
defraud investors even if detailed
disclosures are made. Moreover, as
discussed above, private funds typically
lack fully independent governance
mechanisms more common to other
markets that could help protect
investors from harm in the context of
the activities considered.397
We could, therefore, consider
exceptions that allow certain prohibited
activities if disclosed and if appropriate
governance or other protections are in
place. For example, we could consider
requiring a fund’s LPAC (or other
similar body) or directors to give
approval to any of the activities under
consideration before the adviser may
pursue them. Similarly, we could
require advisers to obtain approval for
any of the activities under consideration
by a majority (either by number or by
interest) of investors. However, we
believe that allowing such activities,
even under such governance, would not
achieve all of the same benefits of
protecting investors, by the same logic
that many of the practices are deceptive
and result in obscured payments, and so
may be used to defraud investors even
if disclosed and governed.
5. Alternatives to the Requirement That
an Adviser To Obtain a Fairness
Opinion in Connection With Certain
Adviser-Led Secondary Transactions
The Commission could consider
requiring advisers to obtain a third party
396 See
397 See
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valuation in connection with certain
adviser-led secondary transactions,
instead of a fairness opinion. We believe
that these third party valuations would
likely involve more diligence of the
proposed transaction than the reviews
conducted in connection with obtaining
a fairness opinion, and therefore,
requiring these valuations could provide
even greater assurances to investors that
the terms of the transaction are fair to
their interests. However, we believe that
obtaining a third-party valuation would
likely be significantly more costly to
obtain. If these costs could be passed on
to participants in these transactions, it
could make them less attractive to
investors as a means to obtain liquidity.
We could also consider changing the
scope of this rule. For example, we
could consider broadening the
application of this rule to, for example,
apply to all advisers, including advisers
that are not required to register as
investment advisers with the
Commission, such as state-registered
advisers and exempt reporting advisers.
Investors would, as a result, receive the
assurance of the fairness of more
adviser-led secondary transactions. The
extension of the proposed rule to apply
to all advisers would, however, likely
impose the costs of obtaining fairness
opinions on smaller funds advised by
unregistered advisers, and for these
types of funds, the cost of obtaining
such opinions would likely be relatively
large compared to the value of fund
assets and fees that the rule is intended
to provide a check on, which could
discourage them from undertaking these
transactions. This could ultimately
reduce liquidity opportunities for fund
investors. Alternatively, we could
provide exemptions from the rule. For
example, an exemption could be
provided where the adviser undertakes
a competitive sale process for the assets
being sold or for certain advisers to
hedge funds or other funds determined
to be liquid funds for whom the
concerns regarding pricing of illiquid
assets may be less relevant. These
exemptions would reduce the costs on
advisers associated with obtaining the
fairness opinion, which could
ultimately reduce costs for investors.
However, we believe that any such
exemptions could reduce the benefits of
the proposed rule associated with
providing greater assurance to investors
of the fairness of the transaction. We
believe that, even under circumstances
where the adviser has conducted a
competitive sales process, the effective
check on this process provided by the
fairness opinion would benefit
investors. Further, even for advisers to
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hedge funds or other funds determined
to be liquid funds who are advising
funds with predominantly highly liquid
securities, we believe that a fairness
opinion would be beneficial to investors
because the conflicts of interest inherent
in structuring and leading a transaction
may, despite the nature of the assets in
the fund, harm investors.398
6. Alternatives to the Prohibition From
Providing Certain Preferential Terms
and Requirement To Disclose All
Preferential Treatment
Instead of requiring that private fund
advisers provide investors and
prospective investors with written
disclosures regarding all preferential
treatment the adviser or its related
persons provided to other investors in
the same fund, the Commission could
consider prohibiting all such terms.
This could provide investors in private
funds with increased confidence that
the adviser’s negotiations with other
investors would not affect their
investment in the private fund. We
preliminarily believe, however, that an
outright prohibition of all preferential
terms may not provide significant
additional benefits beyond prohibitions
on providing certain preferential terms
regarding redemption or information
about portfolio holdings or exposures.
As discussed above, we believe that
certain types of preferential terms raise
relatively few concerns, if disclosed.399
Further, an outright prohibition of all
preferential terms may limit the
adviser’s ability to respond to an
individual investor’s concerns during
the course of attracting capital
investments to private funds.
Further, we could consider
prohibiting all preferential terms
regarding redemption or information
about portfolio holdings or exposures,
rather than just those that the adviser
reasonably expects to have a material,
negative effect on other investors in that
fund or in a substantially similar pool
of assets. This could increase the
investor protections associated with the
rule, by eliminating the risk that a term
not reasonably expected to have a
material negative effect on investors
could, ultimately, harm investors. We
believe, however, that this alternative
would likely provide more limited
benefits and would increase costs
associated with the rule similar to the
above alternatives, for example by
limiting the adviser’s ability to respond
to an individual investor’s concerns
398 Moreover, the costs to liquid fund advisers are
more likely to be limited, as many secondary
transactions by liquid fund advisers are not adviserled and so would not necessitate a fairness opinion.
399 See supra section II.E.
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during the course of attracting capital
investments to private funds.
In addition, for preferential terms not
regarding redemption or information
about portfolio holdings or exposures,
we could consider requiring advisers to
private funds to provide disclosure only
when the term has a material negative
effect on other fund investors. This
could reduce the compliance burden on
advisers associated with the costs of
disclosure. We believe, however, that
limiting disclosure to only those terms
that an adviser determines to have a
material negative effect could reduce an
investor’s ability to recognize the
potential for harm from unforeseen
favoritism toward other investors,
relative to a requirement to disclose all
preferential treatment.
F. Request for Comment
The Commission requests comment
on all aspects of the economic analysis
of the proposed rule. To the extent
possible, the Commission requests that
commenters provide supporting data
and analysis with respect to the
benefits, costs, and effects on
competition, efficiency, and capital
formation of adopting the proposed
amendments or any reasonable
alternatives. In particular, the
Commission asks commenters to
consider the following questions:
• What additional qualitative or
quantitative information should the
Commission consider as part of the
baseline for its economic analysis of
these amendments?
• Has the Commission accurately
characterized the costs and benefits of
proposed rule? If not, why not? Should
any of the costs or benefits be modified?
What, if any, other costs or benefits
should the Commission take into
account? If possible, please offer ways of
estimating these costs and benefits.
What additional considerations can the
Commission use to estimate the costs
and benefits of the proposed
amendments?
• Has the Commission accurately
characterized the effects on competition,
efficiency, and capital formation arising
from the proposed rules? If not, why
not?
• Has the Commission accurately
characterized the economic effects of
the above alternatives? If not, why not?
Should any of the costs or benefits be
modified? What, if any, other costs or
benefits should the Commission take
into account? Are there other reasonable
alternatives to the proposed
amendments? What are the economic
effects of any other alternatives?
• Are there data sources or data sets
that can help the Commission refine its
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estimates of the costs and benefits
associated with the proposed
amendments? If so, please identify
them.
• How would the proposed delivery
of the quarterly statement affect the
reporting practices of advisers,
including the costs and benefits of these
statements? Would advisers add the
required report to the report that they
currently provide to investors? Would
advisers substitute the required report
for an existing report? Explain.
• What are the benefits to investors of
obtaining the information that would be
required under the proposal in a
standardized format that would enable
them to make comparisons across
alternative fund investments? Explain.
Would the benefits to investors vary
based on the investor’s scale of
operations, relationship with the
adviser, or other factors? Explain. Please
provide data, if available, to support
your answer along with details
regarding data sources and
interpretation of statistics, where
appropriate.
• Would the proposed rules
strengthen the bargaining power of
investors in negotiating with private
fund advisers? If so, under what
circumstances, and for what types of
funds and investors would this effect
occur? How would it affect other
investors who do not gain bargaining
power as a result of the proposed rules?
Please explain your answer and provide
supporting data, if possible.
• What would the aggregate total cost
(including but not limited to the audit
fee) be of complying with the new audit
requirement, separately, for (a) funds
that currently receive audits and (b)
funds that would newly receive an audit
under the proposed rule? For each, what
is the current per-fund cost of an audit?
Is the per-fund cost different between
the funds that currently receive audits
and would newly receive audits? If yes,
explain Please include an explanation of
any differences between the funds that
currently receive an audit and the funds
that would newly receive an audit that
would explain the differences in their
per-fund audit costs. Provide
quantitative evidence to support your
explanation, if available.
• Would the proposed rules introduce
new fixed costs of compliance? Would
they cause private funds or fund
advisers to consolidate their operations
to economize on those costs? Please
explain. Provide quantitative evidence
to support your explanation, if
available.
• To what extent do funds currently
provide quarterly statements to
investors, and what is the cost of
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providing these statements? How are
they delivered? How do investors use
them? What are the contents of these
statements currently? How do the
current contents compare with the
contents that would be required under
the proposed rule? Explain.
• We believe that the information in
the new quarterly statements would
supplement the information that
investors currently receive about their
fund investments and that advisers
would not respond to the proposal by
discontinuing any reports to investors.
Is this correct? Why or why not? Please
explain.
• What fee and expense information
is currently available to investors for use
in comparing investment opportunities
among similar funds (sponsored by the
same adviser or different advisers)? How
does this information differ from the
information that advisers would be
required to provide under the proposed
rule? In what way does the lack of this
information affect investor choice or the
ability of investors to monitor fund
performance net of fees and expenses?
• What performance information is
currently available for investors for use
in comparing investment opportunities
among similar funds (sponsored by the
same adviser or different advisers)? How
does this information differ from the
information that advisers would be
required to provide under the proposed
rule?
• How frequently do advisers
currently engage in each of the activities
that would be prohibited under the
proposed rule? Does this frequency vary
depending on the type of adviser or
investor? For each practice, what is the
current business purpose of the activity
and how else might that purpose be
achieved (if the activity were
prohibited)? Please provide quantitative
evidence on the magnitude of the
activity, e.g., how much money do
advisers and related persons receive
from the fee and expense arrangements
that would be prohibited?
• What is the economic effect on
investors, currently, of the activities we
propose to prohibit under the proposed
rule? What empirical evidence is there
that those activities make investors
worse off?
• What data exists regarding the costs
to investors of conflicts of interest in
connection with adviser-led secondary
transactions where an adviser offers
fund investors the option to sell their
interests in the private fund, or to
exchange them for new interests in
another vehicle advised by the adviser?
How do costs vary according to the
presence or absence of the disclosure
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16961
that would be required under the
proposed rule?
• From what sources do investors
receive information about fund
performance: (a) When comparing
alternative prospective fund
investments and (b) for evaluating the
performance of an ongoing und
investment? For example, do investors
obtain this information directly from the
advisers or from a third party? If from
a third party, from what source does the
third party obtain the fund performance
information, and what is the cost of this
information? How does the source vary
with the fund type or third party, if at
all?
• How frequently and under what
conditions are private fund investors
(current and prospective) unable to
obtain information from fund advisers
or third parties on the fund
performance?
• Do investors rely on IRR and MOIC
for evaluating the performance of funds
determined to be illiquid funds? What
additional information do investors use
to evaluate illiquid fund performance?
How frequently do they rely on this
information? From what sources do they
currently obtain this information?
• How do investors who do not have
access to this information evaluate
illiquid fund performance? What
alternative sources of information do
they rely upon?
• Do investors rely on annual total
returns for evaluating the performance
of funds determined to be liquid funds?
When evaluating performance partway
through a current year, do investors rely
on cumulative total return for the
current calendar year? What additional
information do investors use to evaluate
liquid fund performance? How
frequently do they rely on this
information? From what sources do they
currently obtain this information?
• How do investors who do not have
access to this information evaluate
liquid fund performance? What
alternative sources of information do
they rely upon?
VI. Paperwork Reduction Act
A. Introduction
Certain provisions of our proposal
would result in new ‘‘collection of
information’’ requirements within the
meaning of the Paperwork Reduction
Act of 1995 (‘‘PRA’’).400 The proposed
amendments would also have an impact
on the current collection of information
burdens of rules 206(4)–7 and 204–2
under the Advisers Act. The title of the
new collection of information
400 44
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Federal Register / Vol. 87, No. 57 / Thursday, March 24, 2022 / Proposed Rules
requirements we are proposing are
‘‘Rule 211(h)(1)–2 under the Advisers
Act,’’ ‘‘Rule 206(4)–10 under the
Advisers Act,’’ ‘‘Rule 211(h)(2)–2 under
the Advisers Act,’’ and ‘‘Rule 211(h)(2)–
3 under the Advisers Act.’’ The Office
of Management and Budget (‘‘OMB’’)
has not yet assigned control numbers for
these new collections of information.
The titles for the existing collections of
information that we are proposing to
amend are: (i) ‘‘Rule 206(4)–7 under the
Advisers Act (17 CFR 275.206(4)–7)’’
(OMB control number 3235–0585) and
(ii) ‘‘Rule 204–2 under the Advisers Act
(17 CFR 275.204–2)’’ (OMB control
number 3235–0278). The Commission is
submitting these collections of
information to OMB for review and
approval in accordance with 44 U.S.C.
3507(d) and 5 CFR 1320.11. An agency
may not conduct or sponsor, and a
person is not required to respond to, a
collection of information unless it
displays a currently valid OMB control
number.
We discuss below the new collection
of information burdens associated with
new rules 211(h)(1)–2, 206(4)–10,
211(h)(2)–2, and 211(h)(2)–3 as well as
the revised existing collection of
information burdens associated with the
proposed amendments to rules 206(4)–
7 and 204–2. Responses provided to the
Commission in the context of
amendments to rules 206(4)–7 and 204–
2 would be kept confidential subject to
the provisions of applicable law.
Because the information collected
pursuant to new rules 211(h)(1)–2,
211(h)(2)–2, and 211(h)(2)–3 requires
disclosures to existing investors and in
some cases potential investors, these
disclosures would not be kept
confidential. Proposed new rule 206(4)–
10 requires the collection of two types
of information: one type (the audited
financial statements) would be
distributed only to investors in the
private fund, and the other
(notifications to the Commission) would
be kept confidential subject to the
provisions of applicable law.
B. Quarterly Statements
Proposed rule 211(h)(1)–2 would
require an investment adviser registered
or required to be registered with the
Commission to prepare a quarterly
statement that includes certain
standardized disclosures regarding the
cost of investing in the private fund and
the private fund’s performance for any
private fund that it advises, directly or
indirectly, that has at least two full
calendar quarters of operating results,
and distribute the quarterly statement to
the private fund’s investors within 45
days after each calendar quarter end,
unless such a quarterly statement is
prepared and distributed by another
person.401 The quarterly statement
would provide investors with fee and
expense disclosure for the prior
quarterly period or, in the case of a
newly formed private fund initial
account statement, its first two full
calendar quarters of operating results. It
would also provide investors with
certain performance information
depending on whether the fund is
categorized as a liquid fund or an
illiquid fund.402
The collection of information is
necessary to provide private fund
investors with information about their
private fund investments. The quarterly
statement would allow a private fund
investor to compare standardized cost
and performance information across its
private fund investments. We believe
this information would help inform
investment decisions, including
whether to remain invested in certain
private funds or to invest in other
private funds managed by the adviser or
its related persons. More broadly, this
disclosure would help inform investors
about the cost and performance
dynamics of this marketplace and
potentially improve efficiency for future
investments.
Each requirement to disclose
information, offer to provide
information, or adopt policies and
procedures constitutes a ‘‘collection of
information’’ requirement under the
PRA. This collection of information is
found at 17 CFR 275.211(h)(1)–2 and is
mandatory. The respondents to these
collections of information requirements
would be investment advisers that are
registered or required to be registered
with the Commission that advise one or
more private funds.
Based on Investment Adviser
Registration Depository (IARD) data, as
of November 30, 2021, there were
14,832 investment advisers registered
with the Commission. According to this
data, 5,037 registered advisers provide
advice to private funds.403 We estimate
that these advisers would, on average,
each provide advice to 9 private
funds.404 We further estimate that these
private funds would, on average, each
have a total of 67 investors.405 As a
result, an average private fund adviser
would have, on average, a total of 603
investors across all private funds it
advises. As noted above, because the
information collected pursuant to
proposed rule 211(h)(1)–2 requires
disclosures to private fund investors,
these disclosures would not be kept
confidential.
We have made certain estimates of
this data solely for the purpose of this
PRA analysis. The table below
summarizes the initial and ongoing
annual burden estimates associated with
the proposed account statement rule.
TABLE 1—RULE 211(h)(1)–2 PRA ESTIMATES
Internal
initial
burden
hours
Internal annual
burden hours
Wage rate 1
Internal time cost
Annual external cost
burden
khammond on DSKJM1Z7X2PROD with PROPOSALS3
PROPOSED ESTIMATES
Preparation of account statements.
9
11 hours 2 ................
Distribution of account statements
to existing investors.
1.5
3.5 hours 4 ...............
401 See
402 See
proposed rule 211(h)(1)–2.
proposed rule 211(h)(1)–2(d).
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$382 (blended rate for compliance attorney ($373), assistant general counsel
($476), and financial reporting manager
($297)).
$64 (rate for general clerk) .......................
403 See Form ADV, Part 1A, Schedule D, Section
7.B.(1).
404 See Form ADV, Part 1A, Schedule D, Section
7.B.(1).
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$4,202 .....................
$4,030.3
$224 ........................
$930.5
405 See Form ADV, Part 1A, Schedule D, Section
7.B.(1).A., #13.
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Federal Register / Vol. 87, No. 57 / Thursday, March 24, 2022 / Proposed Rules
TABLE 1—RULE 211(h)(1)–2 PRA ESTIMATES—Continued
Internal
initial
burden
hours
Total new annual
burden per private
fund.
Avg. number of private funds per adviser.
Number of PF advisers.
Total new annual burden.
Internal annual
burden hours
Wage rate 1
Internal time cost
Annual external cost
burden
14.5 hours ...............
..............................................................
$4,426 .....................
$4,960.
9 private funds ........
..............................................................
9 private funds ........
9 private funds.
5,037 advisers .........
..............................................................
5,037 advisers .........
2,518.6
657,328.5 hours ......
..............................................................
$200,643,858 ..........
$112,403,250.
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Notes:
1 The Commission’s estimates of the relevant wage rates are based on salary information for the securities industry compiled by the Securities
Industry and Financial Markets Association’s Office Salaries in the Securities Industry 2013. The estimated figures are modified by firm size, employee benefits, overhead, and adjusted to account for the effects of inflation. See Securities Industry and Financial Markets Association, Report
on Management & Professional Earnings in the Securities Industry 2013 (‘‘SIFMA Report’’).
2 This includes the internal initial burden estimate annualized over a three-year period, plus 8 hours of ongoing annual burden hours and takes
into account that there would be four statements prepared each year. The estimate of 11 hours is based on the following calculation: ((9 initial
hours/3 years) + 8 hours of additional ongoing burden hours) = 11 hours.
3 This estimated burden is based on the sum of the estimated wage rate of $496/hour, for 5 hours, ($2,480) for outside legal services and the
estimated wage rate of $310/hour, for 5 hours, ($1,550) for outside accountant assistance, and it assumes that there would be four statements
prepared each year. The Commission’s estimates of the relevant wage rates for external time costs, such as outside legal services, takes into
account staff experience, a variety of sources including general information websites, and adjustments for inflation.
4 This includes the internal initial burden estimate annualized over a three-year period, plus 3 hours of ongoing annual burden hours that takes
into account that there would be four statements prepared each year. The estimate of 3.5 hours is based on the following calculation: ((1.5 initial
hours/3 years) + 3 hours of additional ongoing burden hours) = 3.5 hours.
5 This estimated burden is based on the estimated wage rate of $310/hour, for 3 hours, for outside accounting services, and it assumes that
there would be four statements distributed each year. See supra footnote 409 (regarding wage rates with respect to external cost estimates).
6 We estimate that 50% of advisers will use outside legal and accounting services for these collections of information. This estimate takes into
account that advisers may elect to use outside these services (along with in-house counsel), based on factors such as adviser budget and the
adviser’s standard practices for using such outside services, as well as personnel availability and expertise.
C. Mandatory Private Fund Adviser
Audits
this information in the context of its
examination and oversight program.
Proposed rule 206(4)–10 would
require investment advisers that are
registered or required to be registered to
cause each private fund they advise,
directly or indirectly, to undergo a
financial statement audit at least
annually and upon liquidation that
complies with the proposed rule, unless
the fund otherwise undergoes such an
audit.406 We believe that proposed new
rule 206(4)–10 would protect the fund
and its investors against the
misappropriation of fund assets and that
an audit performed by an independent
public accountant would provide an
important check on the adviser’s
valuation of private fund assets, which
often serve as the basis for the
calculation of the adviser’s fees. The
collection of information is necessary to
provide private fund investors with
information about their private fund
investments and the Commission uses
Each requirement to disclose
information, offer to provide
information, or adopt policies and
procedures constitutes a ‘‘collection of
information’’ requirement under the
PRA. This collection of information is
found at 17 CFR 275.206(4)–10 and is
mandatory to the extent the adviser
provides investment advice to a private
fund. The respondents to these
collections of information requirements
would be investment advisers that are
registered or required to be registered
with the Commission that advise one or
more private funds. All responses
required by the proposed audit rule
would be mandatory. One response type
(the audited financial statements) would
be distributed only to investors in the
private fund and would not be
confidential, and the other (notifications
to the Commission) would be kept
confidential subject to the provisions of
applicable law.
406 See
proposed rule 206(4)–10.
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Based on IARD data, as of November
30, 2021, there were 14,832 investment
advisers registered with the
Commission. According to this data,
5,037 registered advisers provide advice
to private funds.407 We estimate that
these advisers would, on average, each
provide advice to 9 private funds.408 We
further estimate that these private funds
would, on average, each have a total of
67 investors.409 As a result, an average
private fund adviser would have, on
average, a total of 603 investors across
all private funds it advises.
We have made certain estimates of
this data, as discussed below, solely for
the purpose of this PRA analysis. The
table below summarizes the initial and
ongoing annual burden estimates
associated with the proposed rule’s
reporting requirement.
407 See Form ADV, Part 1A, Schedule D, Section
7.B.(1).
408 See Form ADV, Part 1A, Schedule D, Section
7.B.(1).
409 See Form ADV, Part 1A, Schedule D, Section
7.B.(1).A., #13.
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TABLE 2—RULE 206(4)–10 PRA ESTIMATES
Internal
initial
burden
hours
Internal annual
burden hours
Wage rate1
Internal time cost
Annual external cost
burden
PROPOSED ESTIMATES
Distribution of audited financial
statements 2.
Preparation of the
written agreement 5.
Total new annual
burden per private
fund.
Avg. number of private funds per adviser.
Number of advisers
0
6 1.25
Total new annual burden.
$171.73 ...................
$60,000.4
0.92 hours 7 .............
$153.33 (blended rate for intermediate
accountant ($175), general accounting
supervisor ($221), and general clerk
($64)).
$476 (rate for assistant general counsel)
$437.92 ...................
$0.
2.04 hours ...............
..............................................................
$609.65 ...................
$60,000.8
9 private funds ........
..............................................................
9 private funds ........
9 private funds.
5,037 advisers .........
..............................................................
5,037 advisers .........
5,037 advisers.
92,479.32 hours ......
..............................................................
$27,637,263.40 .......
$2,719,980,000.
1.12
hours 3
.............
Notes:
1. See SIFMA Report supra Note 1 to Table 1 Rule 211(h)(1)–2 PRA Estimates.
2. The proposed audit provision would require an adviser to obtain an audit at least annually and upon an entity’s liquidation. To the extent not
prohibited, we anticipate that, in some cases, the fund will bear the audit expense, in other cases the adviser will bear it, and in other instances
both the adviser and fund will share the expense. The liquidation audit would serve as the annual audit for the fiscal year in which it occurs. See
proposed rule 206(4)–10.
3. This estimate takes into account that the financial statements must be distributed once annually under the proposed audit rule and that a liquidation audit would replace a final audit in a year. Based on our experience with similar requirements under the custody rule, we estimate the
hour burden imposed on the adviser relating to the distribution of the audited financial statements with respect to the investors in each fund
should be minimal, approximately one minute per investor. See Custody of Funds or Securities of Clients by Investment Advisers, Investment
Advisers Act Release No. 2968 (Dec. 30, 2009) [75 FR 1455 (Jan. 11, 2010)] (‘‘Custody Rule 2009 Adopting Release’’), at 59–60. We estimate
that the average private fund has 67 investors.
4. Based on our experience, we estimate that the party (or parties) that bears the audit expense would pay an average audit fee of $60,000
per fund. We estimate that individual fund audit fees would tend to vary over an estimated range from $15,000 to $300,000, and that some fund
audit fees would be higher or lower than this range. We understand that the price of the audit has many variables, such as whether it is a liquid
fund or illiquid fund, the number of its holdings, availability of a PCAOB-registered and -inspected auditor, economies of scale, and the location
and size of the auditor.
5. The proposed rule would require the adviser or the private fund to enter into an agreement with the independent public accountant. The
agreement would require the independent public accountant that completes the audit to notify the Commission by electronic means directed to
the Division of Examinations promptly upon certain events. See proposed rule 206(4)–10(e).
6. For purposes of this PRA we assume that, regardless of whether the adviser or the fund enters into the written agreement, the accountant
would incur the hour burden of preparing the agreement. We also assume that, if the fund was party to the agreement, the fund would delegate
the task of reviewing the agreement to the adviser. This estimate also assumes that the adviser would enter into a separate agreement for each
private fund, even if multiple funds use the same auditor. We believe that written agreements are commonplace and reflect industry practice
when a person retains the services of a professional such as an accountant, and they are typically prepared by the accountant in advance. We
therefore estimate that each adviser would spend 1.25 hours to add the required provisions to, or confirm that the required provisions are in, the
written agreement.
7. This includes the internal initial burden estimate annualized over a three-year period, plus 0.5 hours of ongoing annual burden hours, and it
assumes annual reassessment and execution: ((1.25 initial hours/3 years) + 0.5 hours of additional ongoing burden hours) = 0.92 hours.
8. We assume the same frequency of these cost estimates as for the internal annual burden hours estimate.
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D. Adviser-Led Secondaries
Proposed rule 211(h)(2)–2 would
prohibit an adviser registered or
required to be registered from
completing an adviser-led secondary
transaction with respect to any private
fund, unless the adviser, prior to the
closing of the transaction, distributes to
investors in the private fund a fairness
opinion from an independent opinion
provider and a summary of any material
business relationships the adviser or
any of its related persons has, or has had
within the past two years, with the
independent opinion provider.410 We
believe that this proposed requirement
410 See
proposed rule 211(h)(2)–2.
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would provide an important check
against an adviser’s conflicts of interest
in structuring and leading a transaction
from which it may stand to profit at the
expense of private fund investors and
would help ensure that private fund
investors are offered a fair price for their
private fund interests. Specifically, this
requirement is designed to help ensure
that investors receive the benefit of an
independent price assessment, which
we believe will improve their decisionmaking ability and their overall
confidence in the transaction. The
collection of information is necessary to
provide investors with information
about securities transactions in which
they may engage.
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Each requirement to disclose
information, offer to provide
information, or adopt policies and
procedures constitutes a ‘‘collection of
information’’ requirement under the
PRA. This collection of information is
found at 17 CFR 275.211(h)(2)–2 and is
mandatory. The respondents to these
collections of information requirements
would be investment advisers that are
registered or required to be registered
with the Commission that advise one or
more private funds. Based on IARD
data, as of November 30, 2021, there
were 14,832 investment advisers
registered with the Commission.
According to this data, 5,037 registered
advisers provide advice to private
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funds.411 Of these 5,037 advisers, we
estimate that 10%, or approximately 504
advisers, conduct an adviser-led
secondary transaction each year. Of
these advisers, we further estimate that
each conducts one adviser-led
secondary transaction each year. As a
result, an adviser would have
obligations under the proposed rule
with regard to 67 investors.412 As noted
above, because the information
collected pursuant to proposed rule
211(h)(2)–2 requires disclosures to
private fund investors, these disclosures
would not be kept confidential.
We have made certain estimates of
this data solely for the purpose of this
PRA analysis. The table below
summarizes the annual burden
estimates associated with the proposed
rule’s requirements.
TABLE 3—RULE 211(h)(2)–2 PRA ESTIMATES
Internal initial
burden hours
Internal annual
burden hours
Wage rate 1
Internal time cost
Annual external
cost burden
PROPOSED ESTIMATES
hours 2
Preparation/Procurement of fairness
opinion.
0
4
............
1 hour ................
$376.66 (blended rate for compliance attorney
($373), assistant general counsel ($476), and
senior business analyst ($281)).
$424.50 (blended rate for compliance attorney
($373) and assistant general counsel ($476)).
$64 (rate for general clerk) ....................................
Preparation of material business relationship summary.
Distribution of fairness opinion and
material business relationship summary.
0
2 hours ..............
0
$1,506.64 ..........
$40,000.3
$849 ..................
$496.4
$64 ....................
$0.
Total new annual burden per private
fund.
Number of advisers ...........................
........................
7 hours ..............
................................................................................
$2,419.64 ..........
$40,849.
........................
504 advisers 5 ....
................................................................................
504 advisers ......
504 advisers.
Total new annual burden ............
........................
3,528 hours .......
................................................................................
$1,219,498.56 ...
$20,587,896.
Notes:
1 See SIFMA Report supra Note 1 to Table 1 Rule 211(h)(1)–2 PRA Estimates.
2 Includes the time an adviser would spend gathering materials to provide to the independent opinion provider so that the latter can prepare the fairness opinion.
3 This estimated burden is based on our understanding of the general cost of a fairness opinion in the current market. The cost will vary based on, among other
things, the complexity, terms, and size of the adviser-led secondary transaction, as well as the nature of the assets of the fund.
4 This estimated burden is based on the estimated wage rate of $496/hour, for 1 hours, for outside legal services at the same frequency as the internal burden
hours estimate. The Commission’s estimates of the relevant wage rates for external time costs, such as outside legal services, takes into account staff experience, a
variety of sources including general information websites, and adjustments for inflation.
5 We estimate that 10% of all registered private fund advisers conduct in an adviser-led secondary transaction each year.
Proposed rule 211(h)(2)–3 would
prohibit all private fund advisers from
providing preferential terms to certain
investors regarding redemption or
information about portfolio holdings or
exposures.413 The proposed rule would
also prohibit these advisers from
providing any other preferential
treatment to any investor in the private
fund unless the adviser provides written
disclosures to prospective and current
investors in a private fund regarding all
preferential treatment the adviser or its
related persons are providing to other
investors in the same fund. For
prospective investors, the proposed new
rule would require advisers to provide
the written notice prior to the investor’s
investment in the fund.414 For current
investors, the proposed new rule would
require advisers to distribute an annual
update regarding any preferential
treatment provided since the last notice,
if any.415
The proposed new rule is designed to
protect investors and serve the public
interest by requiring disclosure of
preferential treatment afforded to
certain investors. The proposed new
rule would increase transparency in
order to better inform investors
regarding the breadth of preferential
terms, the potential for those terms to
affect their investment in the private
fund, and the potential costs (including
compliance costs) associated with these
preferential terms. Also, this disclosure
would help investors shape the terms of
their relationship with the adviser of the
private fund. The collection of
information is necessary to provide
private fund investors with information
about their private fund investments.
Each requirement to disclose
information, offer to provide
information, or adopt policies and
procedures constitutes a ‘‘collection of
information’’ requirement under the
PRA. This collection of information is
found at 17 CFR 275.211(h)(2)–3 and is
mandatory. The respondents to these
collections of information requirements
would be all investment advisers that
advise one or more private funds. Based
on IARD data, as of November 30, 2021,
there were 12,500 investment advisers
that provide advice to private funds.416
We estimate that these advisers would,
on average, each provide advice to 7
private funds. We further estimate that
these private funds would, on average,
each have a total of 63 investors. As a
result, an average private fund adviser
would have a total of 441 investors
across all private funds it advises. As
noted above, because the information
collected pursuant to proposed rule
211(h)(2)–3 requires disclosures to
private fund investors and prospective
investors, these disclosures would not
be kept confidential.
We have made certain estimates of
this data solely for the purpose of this
PRA analysis. The table below
summarizes the initial and ongoing
annual burden estimates associated with
411 See Form ADV, Part 1A, Schedule D, Section
7.B.(1).
412 See supra section V.B.
413 See proposed rule 211(h)(2)–3(b).
414 See proposed rule 211(h)(2)–3(b)(1).
415 See proposed rule 211(h)(2)–3(b)(2).
416 The following types of private fund advisers,
among others, would be subject to the proposed
rule: Unregistered advisers (i.e., advisers that are
not SEC registered but have a registration
obligation, and those that may be prohibited from
registering with us), foreign private advisers, and
advisers that rely on the intrastate exemption from
SEC registration and/or the de minimis exemption
from SEC registration. However, we are unable to
estimate the number of advisers in each of these
categories because these advisers do not file reports
or other information with the SEC and we are
unable to find reliable, public information. As a
result, the above estimate is based on information
from SEC-registered advisers to private funds,
exempt reporting advisers (at the state and Federal
levels), and state-registered advisers to private
funds. These figures are approximate.
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E. Disclosure of Preferential Treatment
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the proposed rule’s policies and
procedures and annual review
requirements.
TABLE 4—RULE 211(h)(2)–3 PRA ESTIMATES
Internal initial
burden hours
Internal annual
burden hours
Wage rate 1
Internal time cost
Annual external
cost burden
PROPOSED ESTIMATES
Preparation of written notice ..............
4
Provision/distribution of written notice
Total new annual burden per private fund.
Avg. number of private funds per adviser.
Number of advisers ...........................
Total new annual burden ............
3.3
hours 2
$496.3
.........
$424.50 (blended rate for compliance attorney
($373) and assistant general counsel ($476)).
$1,400.85 ..........
0.25
1.13 hours 4 .......
$64 (rate for general clerk) ....................................
$72.32..
........................
4.43 hours .........
................................................................................
$1,473.17 ..........
$496.
........................
7 private funds ..
................................................................................
7 private funds ..
7 private funds.
........................
12,500 advisers
................................................................................
12,500 advisers
9,375 advisers.5
........................
387,625 hours ...
................................................................................
$128,902,375 ....
$32,550,000.
Notes:
1 See SIFMA Report, supra Note 1 to Table 1 Rule 211(h)(1)–2 PRA Estimates.
2 This includes the internal initial burden estimate annualized over a three-year period, plus 2 hours of ongoing annual burden hours and assumes notices would be
issued once annually to existing investors and once quarterly for prospective investors. The estimate of 3.3 hours is based on the following calculation: ((4 initial
hours/3 years) + 2 hours of additional ongoing burden hours) = 3.3 hours. The burden hours associated with reviewing preferential treatment provided to other investors in the same fund and updating the written notice takes into account that (i) most closed-end funds would only raise new capital for a finite period of time and thus
the burden hours would likely decrease after the fundraising period terminates for such funds since they would not continue to seek new investors and would not continue to agree to new preferential treatment for new investors and (ii) most open-end private funds continuously raise capital and thus the burden hours would likely
remain the same year over year since they would continue to seek new investors and would continue to agree to preferential treatment for new investors.
3 This estimated burden is based on the estimated wage rate of $496/hour, for 1 hours, for outside legal services at the same frequency as the internal burden
hours estimate. The Commission’s estimates of the relevant wage rates for external time costs, such as outside legal services, takes into account staff experience, a
variety of sources including general information websites, and adjustments for inflation.
4 This includes the internal initial burden estimate annualized over a three-year period, plus 1.05 hours of ongoing annual burden hours. The estimate of 1.13 hours
is based on the following calculation: ((0.25 initial hours/3 years) + 1.05 hours of additional ongoing burden hours) = 1.13 hours.
5 We estimate that 75% of advisers will use outside legal services for these collections of information. This estimate takes into account that advisers may elect to
use outside legal services (along with in-house counsel), based on factors such as adviser budget and the adviser’s standard practices for using outside legal services, as well as personnel availability and expertise.
F. Written Documentation of Adviser’s
Annual Review of Compliance Program
The proposed amendment to rule
206(4)–7 would require investment
advisers that are registered or required
to be registered to document the annual
review of their compliance policies and
procedures in writing.417 We believe
that such a requirement would focus
renewed attention on the importance of
the annual compliance review process
and would help ensure that advisers
maintain records regarding their annual
compliance review that will allow our
staff to determine whether an adviser
has complied with the compliance rule.
This collection of information is
found at 17 CFR 275.206(4)–7 and is
mandatory. The Commission staff uses
the collection of information in its
examination and oversight program. As
noted above, responses provided to the
Commission in the context of its
examination and oversight program
concerning the proposed amendments
to rule 206(4)–7 would be kept
confidential subject to the provisions of
applicable law.
Based on IARD data, as of November
30, 2021, there were 14,832 investment
advisers registered with the
Commission. In our most recent PRA
submission for rule 206(4)–7, we
estimated a total hour burden of
1,152,663 hours, and the total annual
external cost burden is $0.
The table below summarizes the
initial and ongoing annual burden
estimates associated with the proposed
amendments to rule 204–2.
TABLE 5—RULE 206(4)–7 PRA ESTIMATES
Internal annual
burden hours
Internal time
cost
Wage rate 1
Annual external
cost burden
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PROPOSED ESTIMATES
Written documentation of annual review.
Number of advisers ..........................
3 hours 2 ...........
$1,273.50 .........
$551.3
14,832 advisers
$424.50 (blended rate for compliance attorney
($373) and assistant general counsel ($476)).
.........................................................................
14,832 advisers
7,416 advisers.4
Total new annual burden ..........
44,496 hours ....
..............................................................................
$18,888,552 .....
$4,086,216.
Notes:
1 See SIFMA Report, supra Note 1 to Table 1 Rule 211(h)(1)–2 PRA Estimates.
2 We estimate that these proposed amendments would increase each registered investment adviser’s average annual collection burden under
rule 206(4)–7 by 3 hours.
3 This estimated burden is based on the sum of the estimated wage rate of $496/hour, for 0.5 hours, ($248) for outside legal services and the
estimated wage rate of $310/hour, for 0.5 hours, ($155) for outside accountant assistance.
4 We estimate that 50% of advisers will use outside legal services for these collections of information. This estimate takes into account that advisers may elect to use outside legal services (along with in-house counsel), based on factors such as adviser budget and the adviser’s standard
practices for using outside legal services, as well as personnel availability and expertise.
417 See
proposed rule 206(4)–7(b).
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G. Recordkeeping
The proposed amendments to rule
204–2 would require advisers to private
funds to retain books and records
related to the proposed quarterly
statement rule, the proposed audit rule,
the proposed adviser-led secondaries
rule, and the proposed preferential
treatment rule.418 These proposed
amendments would help facilitate the
Commission’s inspection and
enforcement capabilities.
Specifically, the proposed books and
records amendments related to the
quarterly statement rule would require
advisers to (i) retain a copy of any
quarterly statement distributed to fund
investors as well as a record of each
addressee, the date(s) the statement was
sent, address(es), and delivery
method(s); (ii) retain all records
evidencing the calculation method for
all expenses, payments, allocations,
rebates, offsets, waivers, and
performance listed on any statement
delivered pursuant to the proposed
quarterly statement rule; and (iii) make
and keep books and records
substantiating the adviser’s
determination that the private fund it
manages is a liquid fund or an illiquid
fund pursuant to the proposed quarterly
statement rule.419
The proposed books and records
amendments related to the proposed
audit rule would require advisers to
keep a copy of any audited financial
statements along with a record of each
addressee and the corresponding date(s)
sent, address(es), and delivery
method(s) for each such addressee.420
Additionally, the proposed rule would
require the adviser to keep a record
documenting steps it took to cause a
private fund client with which it is not
in a control relationship to undergo a
financial statement audit that would
comply with the rule.421
The proposed books and records
amendments related to the proposed
adviser-led secondaries rule would
require advisers to retain a copy of any
fairness opinion and summary of
material business relationships
distributed pursuant to the proposed
rule along with a record of each
addressee and the corresponding date(s)
sent, address(es), and delivery
method(s) for each such addressee.422
The proposed books and records
amendments related to the proposed
preferential treatment rule would
require advisers to retain copies of all
written notices sent to current and
prospective investors in a private fund
pursuant to rule 211(h)(2)–3.423 In
addition, advisers would be required to
retain copies of a record of each
addressee and the corresponding dates
sent, addresses, and delivery method for
each addressee.424
The respondents to these collections
of information requirements would be
investment advisers that are registered
16967
or required to be registered with the
Commission that advise one or more
private funds. Based on IARD data, as of
November 30, 2021, there were 14,832
investment advisers registered with the
Commission. According to this data,
5,037 registered advisers provide advice
to private funds.425 We estimate that
these advisers would, on average, each
provide advice to 9 private funds.426 We
further estimate that these private funds
would, on average, each have a total of
67 investors.427 As a result, an average
private fund adviser would have, on
average, a total of 603 investors across
all private funds it advises.
In our most recent PRA submission
for rule 204–2,428 we estimated for rule
204–2 a total hour burden of 2,764,563
hours, and the total annual external cost
burden is $175,980,426. This collection
of information is found at 17 CFR
275.204–2 and is mandatory. The
Commission staff uses the collection of
information in its examination and
oversight program. As noted above,
responses provided to the Commission
in the context of its examination and
oversight program concerning the
proposed amendments to rule 204–2
would be kept confidential subject to
the provisions of applicable law.
The table below summarizes the
initial and ongoing annual burden
estimates associated with the proposed
amendments to rule 204–2.
TABLE 6—RULE 204–2 PRA ESTIMATES
Internal annual
burden hours 1
Internal time
cost
Wage rate 2
Annual
external cost
burden
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PROPOSED ESTIMATES
Retention of account statement and
calculation information; making and
keeping records re liquid/illiquid
fund determination.
Avg. number of private funds per adviser.
Number of advisers ...........................
0.25 hours ........
$68 (blended rate for general clerk ($64) and
compliance clerk ($72)).
$17 ...................
$0
9 private funds ..
................................................................................
9 private funds ..
0
5,037 advisers ..
................................................................................
5,037 advisers ..
0
Sub-total burden .........................
Retention of written notices re preferential treatment.
Avg. number of private funds per adviser.
Number of advisers ...........................
11,333.25 hours
0.5 hours ..........
$770,661 ..........
$34 ...................
0
0
7 private funds ..
................................................................................
$68 (blended rate for general clerk ($64) and
compliance clerk ($72)).
................................................................................
7 private funds ..
0
5,037 advisers ..
................................................................................
5,037 advisers ..
0
Sub-total burden .........................
Retention and distribution of audited
financial statements.
17,629.5 hours
0.25 hours ........
................................................................................
$68 (blended rate for general clerk ($64) and
compliance clerk ($72)).
$1,198,806 .......
$17 ...................
0
0
418 See
419 See
proposed rule 204–2.
proposed rule 204–2(a)(20)(i) and (ii) and
(a)(22).
420 See proposed rule 204–2(a)(21)(i).
421 See proposed rule 204–2(a)(21)(ii).
422 See proposed rule 204–2(a)(23).
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423 See
proposed rule 204–2(a)(7)(v).
424 Id.
425 See Form ADV, Part 1A, Schedule D, Section
7.B.(1).
426 See Form ADV, Part 1A, Schedule D, Section
7.B.(1).
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427 See Form ADV, Part 1A, Schedule D, Section
7.B.(1).A., #13.
428 Supporting Statement for the Paperwork
Reduction Act Information Collection Submission
for Revisions to Rule 204–2, OMB Report, OMB
3235–0278 (Aug. 2021).
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TABLE 6—RULE 204–2 PRA ESTIMATES—Continued
Annual
external cost
burden
Internal annual
burden hours 1
Wage rate 2
Internal time
cost
Avg. number of private funds per adviser.
Number of advisers ...........................
9 private funds ..
................................................................................
9 private funds ..
0
5,037 advisers ..
................................................................................
5,037 advisers ..
0
Sub-total burden .........................
Retention and distribution of fairness
opinion and summary of material
business relationships.
Avg. number of private funds per adviser that conduct an adviser-led
transaction.
Number of advisers ...........................
11,333.25 hours
1 hour ...............
................................................................................
$68 (blended rate for general clerk ($64) and
compliance clerk ($72)).
$770,661 ..........
$68 ...................
0
0
1 private fund ...
................................................................................
1 private fund ...
0
504 advisers 3 ...
................................................................................
504 advisers 4 ...
0
Sub-total burden .........................
504 hours .........
................................................................................
$34,272 ............
0
Total burden ........................
40,800 hours ....
................................................................................
$ 2,774,400 ......
0
Notes:
1 Hour burden and cost estimates for these proposed rule amendments assume the frequency of each collection of information for the substantive rule with which they are associated. For example, the hour burden estimate for recordkeeping obligations associated with the amendments to proposed rule 204–2(a)(20) and (22) would assume the same frequency of collection of information as under proposed rule 211(h)(1)–
2.
2 See SIFMA Report, supra Note 1 to Table 1 Rule 211(h)(1)–2 PRA Estimates.
3 See supra section V.D.
4 Id.
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H. Request for Comment
We request comment on whether
these estimates are reasonable. Pursuant
to 44 U.S.C. 3506(c)(2)(B), the
Commission solicits comments in order
to: (1) Evaluate whether the proposed
collection of information is necessary
for the proper performance of the
functions of the Commission, including
whether the information will have
practical utility; (2) evaluate the
accuracy of the Commission’s estimate
of the burden of the proposed collection
of information; (3) determine whether
there are ways to enhance the quality,
utility, and clarity of the information to
be collected; and (4) determine whether
there are ways to minimize the burden
of the collection of information on those
who are to respond, including through
the use of automated collection
techniques or other forms of information
technology.
Persons wishing to submit comments
on the collection of information
requirements of the proposed
amendments should direct them to the
OMB Desk Officer for the Securities and
Exchange Commission,
MBX.OMB.OIRA.SEC_desk_officer@
omb.eop.gov, and should send a copy to
Vanessa A. Countryman, Secretary,
Securities and Exchange Commission,
100 F Street NE, Washington, DC
20549–1090, with reference to File No.
S7–03–22. OMB is required to make a
decision concerning the collections of
information between 30 and 60 days
after publication of this release;
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therefore a comment to OMB is best
assured of having its full effect if OMB
receives it within 30 days after
publication of this release. Requests for
materials submitted to OMB by the
Commission with regard to these
collections of information should be in
writing, refer to File No. S7–03–22, and
be submitted to the Securities and
Exchange Commission, Office of FOIA
Services, 100 F Street NE, Washington,
DC 20549–2736.
VII. Initial Regulatory Flexibility
Analysis
The Commission has prepared the
following Initial Regulatory Flexibility
Analysis (‘‘IRFA’’) in accordance with
section 3(a) of the Regulatory Flexibility
Act (‘‘RFA’’).429 It relates to the
following proposed rules and rule
amendments under the Advisers Act: (i)
Proposed rule 211(h)(1)–1; (ii) proposed
rule 211(h)(1)–2; (iii) proposed rule
206(4)–10; (iv) proposed rule 211(h)(2)–
1; (v) proposed rule 211(h)(2)–2; (vi)
proposed rule 211(h)(2)–3; (vii)
proposed amendments to rule 204–2;
and (viii) proposed amendments to rule
206(4)–7.
A. Reasons for and Objectives of the
Proposed Action
1. Proposed Rule 211(h)(1)–1
We are proposing new rule 211(h)(1)–
1 under the Advises Act (the
‘‘definitions rule’’), which would
contain numerous definitions for
purposes of proposed rules 211(h)(1)–2,
206(4)–10, 211(h)(2)–1, 211(h)(2)–2, and
211(h)(2)–3.430 We chose to include
these definitions in a single rule for ease
of reference, consistency, and brevity.
2. Proposed Rule 211(h)(1)–2
We are proposing new rule 211(h)(1)–
2 under the Advisers Act, which
requires any investment adviser
registered or required to be registered
with the Commission that provides
investment advice to a private fund that
has at least two full calendar quarters of
operating results to prepare and
distribute a quarterly statement to
private fund investors that includes
certain standardized disclosures
regarding the cost of investing in the
private fund and the private fund’s
performance.431 We believe that
providing this information to private
fund investors in a simple and clear
format is appropriate and in the public
interest and will improve investor
protection and investor decision
making. The reasons for, and objectives
of, proposed rule 211(h)(1)–2 are
discussed in more detail in section II.A,
above. The burdens of this requirement
on small advisers are discussed below
as well as above in sections V and VI,
which discuss the burdens on all
advisers. The professional skills
required to meet these specific burdens
also are also discussed in section VI.
430 See
429 5
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proposed rule 211(h)(1)–1.
proposed rule 211(h)(1)–2.
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3. Proposed Rule 206(4)–10
We are proposing new rule 206(4)-10
under the Advisers Act, which would
generally require all investment advisers
that are registered or required to be
registered with the Commission to have
their private fund clients undergo a
financial statement audit at least
annually and upon liquidation
containing certain prescribed elements,
which are described above in section
II.B. The proposed rule is designed to
provide protection for the fund and its
investors against the misappropriation
of fund assets and to provide an
important check on the adviser’s
valuation of private fund assets, which
often serve as the basis for the
calculation of the adviser’s fees. The
reasons for, and objectives of, the
proposed audit rule are discussed in
more detail in section II.B, above. The
burdens of these requirements on small
advisers are discussed below as well as
above in sections V and VI, which
discuss the burdens on all advisers. The
professional skills required to meet
these specific burdens also are
discussed in section VI.
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4. Proposed Rule 211(h)(2)–1
Proposed rule 211(h)(2)-1 would
prohibit all private fund advisers from,
directly or indirectly, engaging in
certain sales practices, conflicts of
interest, and compensation schemes that
are contrary to the public interest and
the protection of investors. Specifically,
the rule would prohibit an adviser from:
(1) Charging certain fees and expenses
to a private fund or portfolio investment
(including accelerated monitoring fees,
fees or expenses associated with an
examination or investigation of the
adviser or its related persons by
governmental or regulatory authorities,
regulatory or compliance expenses or
fees of the adviser or its related persons,
or fees and expenses related to a
portfolio investment (or potential
portfolio investment) on a non-pro rata
basis when multiple private funds and
other clients advised by the adviser or
its related persons have invested (or
propose to invest) in the same portfolio
investment); (2) reducing the amount of
any adviser clawback by the amount of
certain taxes; (3) seeking
reimbursement, indemnification,
exculpation, or limitation of its liability
by the private fund or its investors for
a breach of fiduciary duty, willful
misfeasance, bad faith, negligence, or
recklessness in providing services to the
private fund; and (4) borrowing money,
securities, or other fund assets, or
receiving a loan or an extension of
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credit, from a private fund client.432
Each of these prohibitions is described
in more detail above in section II.D. As
discussed above, we believe that these
sales practices, conflicts of interest, and
compensation schemes must be
prohibited. The proposed rule would
prohibit these activities regardless of
whether the private fund documents
permit such activities or the adviser
otherwise discloses the practices and
regardless of whether the private fund
investors have consented to the
activities. Also, the proposed rule
would prohibit these activities even if
they are performed indirectly, for
example by an adviser’s related persons,
because the activities have an equal
potential to harm investors regardless of
whether the adviser engages in the
activity directly or indirectly. The
reasons for, and objectives of, the
proposed rule are discussed in more
detail in section II.D, above. The
burdens of these requirements on small
advisers are discussed below as well as
above in sections V and VI, which
discuss the burdens on all advisers. The
professional skills required to meet
these specific burdens also are
discussed in section VI.
5. Proposed Rule 211(h)(2)–2
We are proposing new rule 211(h)(2)–
2 under the Advisers Act, which
generally would make it unlawful for an
adviser that is registered or required to
be registered with the Commission to
complete an adviser-led secondary
transaction with respect to any private
fund, where an adviser (or its related
persons) offers fund investors the option
to sell their interests in the private fund,
or to convert or exchange them for new
interests in another vehicle advised by
the adviser or its related persons, unless
the adviser, prior to the closing of the
transaction, distributes to investors in
the private fund a fairness opinion from
an independent opinion provider and a
summary of any material business
relationships the adviser or any of its
related persons has, or has had within
the past two years, with the
independent opinion provider. The
specific requirements of the proposed
rule are described above in section II.C.
The proposed rule is designed to
provide an important check against an
adviser’s conflicts of interest in
structuring and leading a transaction
from which it may stand to profit at the
expense of private fund investors. The
reasons for, and objectives of, the
proposed rule are discussed in more
detail in section II.C above. The burdens
of these requirements on small advisers
are discussed below as well as above in
sections V and VI, which discuss the
burdens on all advisers. The
professional skills required to meet
these specific burdens also are
discussed in section VI.
6. Proposed Rule 211(h)(2)–3
Proposed rule 211(h)(2)–3 would
prohibit a private fund adviser, directly
or indirectly, from (1) granting an
investor in a private fund or in a
substantially similar pool of assets the
ability to redeem its interest 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; or
(2) providing information regarding the
portfolio holdings or exposures of the
private fund, or of a substantially
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
substantially similar pool of assets.433
The proposed rule would also prohibit
these advisers from providing any other
preferential treatment to any investor in
a private fund unless the adviser
provides written disclosures to
prospective and current investors in the
private fund regarding all preferential
treatment the adviser or its related
persons provided to other investors in
the same fund.434 These requirements
are described above in section II.E. The
proposed rule is designed to eliminate
sales practices that present a conflict of
interest between the adviser and the
private fund client that are contrary to
the public interest and protection of
investors. The disclosure elements of
the proposed rule are designed to also
help investors shape the terms of their
relationship with the adviser of the
private fund. The reasons for, and
objectives of, the proposed rule are
discussed in more detail in section II.E,
above. The burdens of these
requirements on small advisers are
discussed below as well as above in
sections V and VI, which discuss the
burdens on all advisers. The
professional skills required to meet
these specific burdens also are
discussed in section VI.
7. Proposed Amendments to Rule 204–
2
We are also proposing related
amendments to rule 204–2, the books
and records rule, which sets forth
various recordkeeping requirements for
registered investment advisers. We are
433 See
432 See
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434 See
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proposed rule 211(h)(2)–3.
proposed rule 211(h)(2)–3(b).
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proposing to amend the current rule to
require investment advisers to private
funds to make and keep records relating
to the quarterly statements required
under proposed rule 211(h)(1)–2, the
financial statement audits performed
under proposed rule 206(4)–10, fairness
opinions required under proposed rule
211(h)(2)–2, and disclosure of certain
types of preferential treatment required
under proposed rule 211(h)(2)–3. The
reasons for, and objectives of, the
proposed amendments to the books and
records rule are discussed in more detail
in sections II.A, II.B, II.C, II.E, V, above.
The burdens of these requirements on
small advisers are discussed below as
well as above in sections V and VI,
which discuss the burdens on all
advisers. The professional skills
required to meet these specific burdens
also are discussed in section VI.
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8. Proposed Amendments to Rule
206(4)–(7)
We are proposing amendments to rule
206(4)–7 to require all SEC-registered
advisers to document the annual review
of their compliance policies and
procedures in writing, as described
above in section III. The proposed
amendments are designed to focus
renewed attention on the importance of
the annual compliance review process
and would better enable our staff to
determine whether an adviser has
complied with the review requirement
of the compliance rule. The reasons for,
and objectives of, the proposed rule are
discussed in more detail in section III,
above. The burdens of these
requirements on small advisers are
discussed below as well as above in
sections V and VI, which discuss the
burdens on all advisers. The
professional skills required to meet
these specific burdens also are
discussed in section VI.
B. Legal Basis
The Commission is proposing new
rules 211(h)(1)–2, 211(h)(2)–1,
211(h)(2)–2, 211(h)(2)–3, and 206(4)–10
under the Advisers Act under the
authority set forth in sections 203(d),
206(4), 211(a), and 211(h) of the
Investment Advisers Act of 1940 (15
U.S.C. 80b–3(d), 80b–6(4) and 80b–11(a)
and (h)). The Commission is proposing
amendments to rule 204–2 under the
Advisers Act under the authority set
forth in sections 204 and 211 of the
Investment Advisers Act of 1940 (15
U.S.C. 80b–4 and 80b–11). The
Commission is proposing amendments
to rule 206(4)–7 under the Advisers Act
under the authority set forth in sections
203(d), 206(4), and 211(a) of the
Investment Advisers Act of 1940 (15
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U.S.C. 80b–3(d), 80b–6(4), and 80b–
11(a)).
C. Small Entities Subject to Rules
In developing these proposals, we
have considered their potential impact
on small entities that would be subject
to the proposed rules and amendments.
Some of the proposed rules and
amendments would affect many, but not
all, investment advisers registered with
the Commission, including some small
entities, the proposed amendments to
rule 206(4)–7 would affect all
investment advisers that are registered,
or required to be registered, with the
Commission, including some small
entities, and proposed rules 211(h)(2)–1
and 211(h)(2)–3 would apply to all
advisers to private funds (even if not
registered), including some small
entities. Proposed rule 211(h)(1)–1
would affect all advisers, including all
that are small entities, regardless of
whether they are registered or advise
private funds. Under Commission rules,
for the purposes of the Advisers Act and
the RFA, an investment adviser
generally is a small entity if it: (1) Has
assets under management having a total
value of less than $25 million; (2) did
not have total assets of $5 million or
more on the last day of the most recent
fiscal year; and (3) does not control, is
not controlled by, and is not under
common control with another
investment adviser that has assets under
management of $25 million or more, or
any person (other than a natural person)
that had total assets of $5 million or
more on the last day of its most recent
fiscal year.435
Other than the proposed definitions
rule, prohibitions rule and preferential
treatment rule, our proposed rules and
amendments would not affect most
investment advisers that are small
entities (‘‘small advisers’’) because those
rules apply only to registered advisers,
and small registered advisers are
generally registered with one or more
state securities authorities and not with
the Commission. Under section 203A of
the Advisers Act, most small advisers
are prohibited from registering with the
Commission and are regulated by state
regulators. Based on IARD data, we
estimate that as of November 30, 2021,
approximately 594 SEC-registered
advisers are small entities under the
RFA.436 All of these advisers would be
affected by the proposed amendments to
the compliance rule, and we estimate
that approximately 29 advise one or
more private funds and would,
435 17
CFR 275.0–7(a) (Advisers Act rule 0–7(a)).
on SEC-registered investment adviser
responses to Items 5.F. and 12 of Form ADV.
436 Based
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therefore, be affected by the proposed
quarterly statement rule, audit rule, and
secondaries rule.
The proposed prohibited activities
rule and the proposed preferential
treatment rule, however, would have an
impact on all investment advisers to
private funds, regardless of whether
they are registered with the
Commission, one or more state
securities authorities, or are
unregistered. It is difficult for us to
estimate the number of advisers not
registered with us that have private fund
clients. However, we are able to provide
the following estimates based on IARD
data. As of November 30, 2021, there are
5,022 ERAs, all of whom advise private
funds, by definition.437 All ERAs would,
therefore, be subject to the rules that
would apply to all private fund
advisers. We estimate that there are no
ERAs that would meet the definition of
‘‘small entity.’’ 438 We do not have a
method for estimating the number of
state-registered advisers to private funds
that would meet the definition of ‘‘small
entity.’’
Additionally, the proposed prohibited
activities rule and the proposed
preferential treatment rule would apply
to other advisers that are not registered
with the SEC or with the states and that
do not make filings with either the SEC
or states. This includes foreign private
advisers,439 advisers that are entirely
unregistered, and advisers that rely on
the intrastate exemption from SEC
registration and/or the de minimis
exemption from SEC registration. We
are unable to estimate the number of
advisers in each of these categories
because these advisers do not file
reports or other information with the
SEC and we are unable to find reliable,
public information. As a result, our
estimates are based on information from
SEC-registered advisers to private funds,
exempt reporting advisers (at the state
and Federal levels), and state-registered
advisers to private funds.
The proposed definitions rule would
affect all advisers, but not unless the
adviser is also affected by one of the
rules discussed above. It has no
independent substantive requirements
or economic impacts. Therefore, the
number of small advisers affected by
this rule is accounted for in those
437 See section 203(l) of the Advisers Act and 17
CFR 275.203(m)–1 (rule 203(m)–1 thereunder).
438 In order for an adviser to be an SEC ERA it
would first need to have an SEC registration
obligation, and an adviser with that little in assets
under management (i.e., assets under management
that is low enough to allow the adviser to qualify
as a small entity) would not have an SEC
registration obligation.
439 See section 202(a)(30) of the Advisers Act
(defining ‘‘foreign private adviser’’).
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discussions and not separately and
additionally delineated.
advisers associated with our proposed
amendments would be $1,802,466.440
D. Projected Reporting, Recordkeeping,
and Other Compliance Requirements
3. Proposed Rule 206(4)–10
Proposed rule 206(4)–10 would
impose certain compliance
requirements on investment advisers,
including those that are small entities.
All registered investment advisers that
provide investment advice, including
small entity advisers, would be required
to comply with the proposed rule’s
requirements to have their private fund
clients undergo a financial statement
audit (at least annually and upon
liquidation) and distribute audited
financial statements to private fund
investors. The proposed requirements,
including compliance and related
recordkeeping requirements that would
be imposed under proposed
amendments to rule 204–2 and rule
206(4)–7, are summarized in this IRFA
(section VII.A. above). All of these
proposed requirements are also
discussed in detail, above, in section II,
and these requirements and the burdens
on respondents, including those that are
small entities, are discussed above in
sections V and VI (the Economic
Analysis and Paperwork Reduction Act
Analysis, respectively) and below. The
professional skills required to meet
these specific burdens are also
discussed in section VI.
As discussed above, there are
approximately 29 small advisers to
private funds currently registered with
us, and we estimate that 100 percent of
these advisers would be subject to the
proposed rule 206(4)–10. As discussed
above in our Paperwork Reduction Act
Analysis in section V above, proposed
rule 206(4)–10 under the Advisers Act
would create a new annual burden of
approximately 18.36 hours per adviser,
or 532.44 hours in aggregate for small
advisers. We therefore expect the annual
monetized aggregate cost to small
advisers associated with our proposed
amendments would be
$15,819,118.65.441
1. Proposed Rule 211(h)(1)–1
Proposed rule 211(h)(1)–1 would not
impose any reporting, recordkeeping, or
other compliance requirements on
investment advisers because it has no
independent substantive requirements
or economic impacts. The rule would
not affect an adviser unless it was
complying with proposed rule
211(h)(1)–2, 206(4)–10, 211(h)(2)–1,
211(h)(2)–2, or 211(h)(2)–3, each of
which is discussed below.
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2. Proposed Rule 211(h)(1)–2
Proposed rule 211(h)(1)–2 would
impose certain compliance
requirements on investment advisers,
including those that are small entities.
It would require any investment adviser
registered or required to be registered
with the Commission that provides
investment advice to a private fund that
has at least two full calendar quarters of
operating results to prepare and
distribute quarterly statements with
certain fee and expense and
performance disclosure to private fund
investors. The proposed requirements,
including compliance and related
recordkeeping requirements that would
be required under the proposed
amendments to rule 204–2 and rule
206(4)–7, are summarized in this IRFA
(section VII above). All of these
proposed requirements are also
discussed in detail, above, in section II,
and these requirements and the burdens
on respondents, including those that are
small entities, are discussed above in
sections V and VI (the Economic
Analysis and Paperwork Reduction Act
Analysis, respectively) and below. The
professional skills required to meet
these specific burdens are also
discussed in section VI.
As discussed above, there are
approximately 29 small advisers to
private funds currently registered with
us, and we estimate that 100 percent of
these advisers would be subject to the
proposed rule 211(h)(1)–2. As discussed
in our Paperwork Reduction Act
Analysis in section V above, the
proposed rule 211(h)(1)–2 under the
Advisers Act, which would require
advisers to prepare and distribute
quarterly statements, would create a
new annual burden of approximately
130.5 hours per adviser, or 3,784.5
hours in aggregate for small advisers.
We therefore expect the annual
monetized aggregate cost to small
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4. Proposed Rule 211(h)(2)–1
Proposed rule 211(h)(2)–1 would
impose certain compliance
requirements on investment advisers,
including those that are small entities.
Proposed rule 211(h)(2)–1 would
prohibit all private fund advisers from
engaging in certain sales practices,
440 This includes the internal time cost and the
annual external cost burden and assumes that, for
purposes of the annual external cost burden, 50%
of small advisers will use outside legal services, as
set forth in the PRA estimates table.
441 This includes the internal time cost and the
annual external cost burden, as set forth in the PRA
estimates table.
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16971
conflicts of interest, and compensation
schemes that are contrary to the public
interest and the protection of investors.
Specifically, the rule would prohibit an
adviser from: (1) Charging certain fees
and expenses to a private fund or
portfolio investment (including
accelerated monitoring fees, fees or
expenses associated with an
examination or investigation of the
adviser or its related persons by
governmental or regulatory authorities,
regulatory or compliance expenses or
fees of the adviser or its related persons,
or fees and expenses related to a
portfolio investment (or potential
portfolio investment) on a non-pro rata
basis when multiple private funds and
other clients advised by the adviser or
its related persons have invested (or
propose to invest) in the same portfolio
investment); (2) reducing the amount of
any adviser clawback by the amount of
certain taxes; (3) seeking
reimbursement, indemnification,
exculpation, or limitation of its liability
by the private fund or its investors for
a breach of fiduciary duty, willful
misfeasance, bad faith, negligence, or
recklessness in providing services to the
private fund; and (4) borrowing money,
securities, or other fund assets, or
receiving a loan or an extension of
credit from a private fund client. All of
these proposed requirements are also
discussed in detail, above, in section II,
and these requirements and the burdens
on respondents, including those that are
small entities, are discussed above in
section V (the Economic Analysis) and
below.
As discussed above, there are
approximately 29 small advisers to
private funds currently registered with
us, and we estimate that 100 percent of
these advisers would be subject to the
proposed rule 211(h)(2)–1. As discussed
above, we estimate that there are no
ERAs that would meet the definition of
‘‘small entity’’ and we do not have a
method for estimating the number of
state-registered advisers to private funds
that would meet the definition of ‘‘small
entity.’’ 442
5. Proposed Rule 211(h)(2)–2
Proposed rule 211(h)(2)–2 would
impose certain compliance
requirements on investment advisers,
including those that are small entities.
The rule generally would make it
unlawful for an adviser that is registered
or required to be registered with the
Commission to complete an adviser-led
secondary transaction with respect to
any private fund, where an adviser (or
its related persons) offers fund investors
442 See
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the option to sell their interests in the
private fund, or to convert or exchange
them for new interests in another
vehicle advised by the adviser or its
related persons, unless the adviser, prior
to the closing of the transaction,
distributes to investors in the private
fund a fairness opinion from an
independent opinion provider and a
summary of any material business
relationships the adviser or any of its
related persons has, or has had within
the past two years, with the
independent opinion provider . The
proposed requirements, including
compliance and related recordkeeping
requirements that would be imposed
under proposed amendments to rule
204–2 and 206(4)–7, are summarized in
this IRFA (section VII above). All of
these proposed requirements are also
discussed in detail, above, in section II,
and these requirements and the burdens
on respondents, including those that are
small entities, are discussed above in
sections V and VI (the Economic
Analysis and Paperwork Reduction Act
Analysis, respectively) and below. The
professional skills required to meet
these specific burdens also are
discussed in section VI.
As discussed above, there are
approximately 29 small advisers to
private funds currently registered with
us, and we estimate that 100 percent of
these advisers would be subject to
proposed rule 211(h)(2)–2. As discussed
above in our Paperwork Reduction Act
Analysis in section V above, proposed
rule 211(h)(2)–2 under the Advisers Act
would create a new annual burden of
approximately 7 hours per adviser, or 21
hours in aggregate for small advisers.443
We therefore expect the annual
monetized aggregate cost to small
advisers associated with our proposed
amendments would be $129,805.92.444
6. Proposed Rule 211(h)(2)–3
Proposed rule 211(h)(2)–3 would
impose certain compliance
requirements on investment advisers,
including those that are small entities.
Proposed rule 211(h)(2)–3 would
prohibit a private fund adviser,
including indirectly through its related
persons, from (1) granting an investor in
the private fund or in a substantially
similar pool of assets the ability to
redeem its interest on terms that the
adviser reasonably expects to have a
material, negative effect on other
443 Similar to the PRA analysis, we assume that
10% (∼3) of all small advisers will conduct an
adviser-led secondary transaction on an annual
basis.
444 This includes the internal time cost and the
annual external cost burden, as set forth in the PRA
estimates table.
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investors in that private fund or in a
substantially similar pool of assets; and
(2) providing information regarding the
private fund’s portfolio holdings or
exposures of the private fund or of a
substantially 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 substantially similar pool of
assets. The rule would also prohibit
these advisers from providing any other
preferential treatment to any investor in
the private fund unless the adviser
provides written disclosures to
prospective and current investors in the
private fund regarding all preferential
treatment the adviser or its related
persons provided to other investors in
the same fund. The proposed
requirements, including compliance and
related recordkeeping requirements that
would be imposed under proposed
amendments to rule 204–2 and 206(4)–
7, are summarized in this IRFA (section
VII above). All of these proposed
requirements are also discussed in
detail, above, in section II, and these
requirements and the burdens on
respondents, including those that are
small entities, are discussed above in
sections V and VI (the Economic
Analysis and Paperwork Reduction Act
Analysis, respectively) and below. The
professional skills required to meet
these specific burdens also are
discussed in section VI.
As discussed above, there are
approximately 29 small advisers to
private funds currently registered with
us, and we estimate that 100 percent of
these advisers would be subject to the
proposed rule 211(h)(2)–3. As discussed
above, we estimate that there are no
ERAs that would meet the definition of
‘‘small entity’’ and we do not have a
method for estimating the number of
state-registered advisers to private funds
that would meet the definition of ‘‘small
entity.’’ 445 As discussed above in our
Paperwork Reduction Act Analysis in
section VI above, proposed rule
211(h)(2)–3 under the Advisers Act
would create a new annual burden of
approximately 31.01 hours per adviser,
or 899.29 hours in aggregate for small
advisers.446 We therefore expect the
445 See
supra section VI.C.
following types of private fund advisers,
among others, would be subject to the proposed
rule: Unregistered advisers (i.e., advisers that are
not SEC registered but have a registration
obligation), foreign private advisers, and advisers
that rely on the intrastate exemption from SEC
registration and/or the de minimis exemption from
SEC registration. However, we are unable to
estimate the number of advisers in each of these
categories because these advisers do not file reports
or other information with the SEC and we are
446 The
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annual monetized aggregate cost to
small advisers associated with our
proposed amendments would be
$374,569.51.447
7. Proposed Amendments to Rule 204–
2
The proposed amendments to rule
204–2 would impose certain
recordkeeping requirements on
investment advisers to private funds,
including those that are small entities.
All registered investment advisers to
private funds, including small entity
advisers, would be required to comply
with recordkeeping amendments. While
all SEC-registered investment advisers,
and advisers that are required to be
registered, are subject to rule 204–2
under the Advisers Act, our proposed
amendments to rule 204–2 would only
impact private fund advisers that are
SEC registered. The proposed
amendments are summarized in this
IRFA (section VII above). The proposed
amendments are also discussed in
detail, above, in section II, and the
requirements and the burdens on
respondents, including those that are
small entities, are discussed above in
sections V and VI (the Economic
Analysis and Paperwork Reduction Act
Analysis, respectively) and below. The
professional skills required to meet
these specific burdens also are
discussed in section VI.
As discussed above, there are
approximately 29 small advisers to
private funds currently registered with
us, and we estimate that 100 percent of
advisers registered with us would be
subject to the proposed amendments to
rule 204–2. As discussed above in our
Paperwork Reduction Act Analysis in
section VI above, the proposed
amendments to rule 204–2 under the
Advisers Act, which would require
advisers to retain certain copies of
documents required under proposed
rules 206(4)–10, 211(h)(1)–2, 211(h)(2)–
2, and 211(h)(2)–3 would create a new
annual burden of approximately 9 hours
per adviser, or 261 hours in aggregate
for small advisers. We therefore expect
the annual monetized aggregate cost to
small advisers associated with our
unable to find reliable, public information. As a
result, the above estimate is based on information
from SEC-registered advisers to private funds,
exempt reporting advisers (at the state and Federal
levels), and state-registered advisers to private
funds. These figures are approximate.
447 This includes the internal time cost and the
annual external cost burden and assumes that, for
purposes of the annual external cost burden, 75%
of small advisers will use outside legal services, as
set forth in the PRA estimates table.
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proposed amendments would be
$17,748.448
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8. Proposed Amendments to Rule
206(4)–7
Proposed amendments to rule 206(4)–
7 would impose certain compliance
requirements on investment advisers,
including those that are small entities.
All registered investment advisers, and
advisers that are required to be
registered, would be required to
document the annual review of their
compliance policies and procedures in
writing. The proposed requirements are
summarized in this IRFA (section VII
above). All of these proposed
requirements are also discussed in
detail, above, in section III, and these
requirements and the burdens on
respondents, including those that are
small entities, are discussed above in
sections V and VI (the Economic
Analysis and Paperwork Reduction Act
Analysis, respectively) and below. The
professional skills required to meet
these specific burdens also are
discussed in section VI.
As discussed above, there are
approximately 29 small advisers
currently registered with us, and we
estimate that 100 percent of these
advisers would be subject to the
proposed amendments to rule 206(4)–7.
As discussed above in our Paperwork
Reduction Act Analysis in section VI
above, these amendments would create
a new annual burden of approximately
3 hour per adviser, or 87 hours in
aggregate for small advisers. We
therefore expect the annual monetized
aggregate cost to small advisers
associated with our proposed
amendments would be $44,921.449
E. Duplicative, Overlapping, or
Conflicting Federal Rules
There are no duplicative, overlapping,
or conflicting Federal rules with respect
to the specific requirements of proposed
rule 211(h)(1)–1, 211(h)(1)–2, 211(h)(2)–
1, 211(h)(2)–2, 211(h)(2)–3, or the
proposed amendments to rule 204–2 or
rule 206(4)–7. We recognize that private
fund advisers are prohibited from
making misstatements or materially
misleading statements to investors
under rule 206(4)–8. To the extent there
is any overlap between the proposed
rules and rule 206(4)–8, we believe that
any additional costs to advisers to
448 This includes the internal time cost and the
annual external cost burden, as set forth in the PRA
estimates table.
449 This includes the internal time cost and the
annual external cost burden and assumes that, for
purposes of the annual external cost burden, 50%
of small advisers will use outside legal services, as
set forth in the PRA estimates table.
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private funds would be minimal, as they
can assume that conduct that would
raise issues under any of the specific
provisions of the proposed rules would
also be prohibited under rule 206(4)–8.
To the extent there is any overlap
between the requirements of proposed
rule 211(h)(1)–2 and Form ADV Part 2,
it is minimal, and it is complementary,
not contradictory. For example, Form
ADV Part 2 requires advisers to disclose
what fees the adviser charges, such as a
2% management fee based on its clients’
assets that it manages. The proposed
rule would require advisers to disclose
what amount was actually charged to a
private fund client (e.g., $200,000).
There is significant duplication and
overlap of the requirements of proposed
rule 206(4)–10 and rule 206(4)–2
because proposed rule 206(4)–10 is
drawn from the option to comply with
rule 206(4)–2’s account statement and
surprise examination requirements by
having pooled investment vehicle
clients undergo a financial statement
audit and distribute the financial
statements to the investors in the pools.
Similarities between these rules should
result in minimal new compliance
burdens for private fund advisers that
have chosen to comply with the audit
provision of rule 206(4)–2, however. For
private fund advisers that have not
chosen to comply with the audit
provision of rule 206(4)–2, proposed
rule 206(4)–10 will result in new
compliance burdens, but not ones that
contradict rule 206(4)–2. These advisers
can choose to mitigate, as much as
possible, their compliance burdens by
electing to comply with rule 206(4)–2’s
audit provision in lieu of the account
statement and surprise examination
requirements, though this option may be
limited for some advisers if they also
have clients for which the adviser is
unable to choose to rely on the audit
provision of the custody rule. We
believe these additional compliance
burdens are justified because an audit
by an independent public accountant
would provide an important check on
the adviser’s valuation of private fund
assets, which often serve as the basis for
calculating the adviser’s fees.
F. Significant Alternatives
The RFA directs the Commission to
consider significant alternatives that
would accomplish the stated objective,
while minimizing any significant
adverse impact on small entities. In
connection with the proposed rules and
rule amendments, the Commission
considered the following alternatives: (i)
The establishment of differing
compliance or reporting requirements or
timetables that take into account the
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16973
resources available to small entities; (ii)
the clarification, consolidation, or
simplification of compliance and
reporting requirements under the
proposed rules and rule amendments for
such small entities; (iii) the use of
performance rather than design
standards; and (iv) an exemption from
coverage of the proposed rules and rule
amendments, or any part thereof, for
such small entities.
Regarding the first and fourth
alternatives, we do not believe that
differing compliance or reporting
requirements or an exemption from
coverage of the proposed rules and rule
amendments, or any part thereof, for
small entities, would be appropriate or
consistent with investor protection.
Because the protections of the Advisers
Act are intended to apply equally to
clients of both large and small advisory
firms, it would be inconsistent with the
purposes of the Act to specify different
requirements for small entities under
the proposed rules and rule
amendments.
Regarding the second alternative, the
proposed prohibited activities rule and
the proposed preferential treatment rule
are particularly intended to provide
clarification to all private fund advisers,
not just small advisers, as to what the
Commission considers to be conduct
that would be prohibited under section
206 of the Act and contrary to the public
interest and protection of investors
under section 211 of the Act. Despite
our examination and enforcement
efforts, this type of inappropriate
conduct persists; these proposed rules
will provide clarity of our views of this
conduct to all private fund advisers.
Similarly, we also have endeavored to
consolidate and simplify the
compliance with both proposed rules, as
well as disclosure requirements under
the proposed preferential treatment rule,
for all private fund advisers.
Regarding the third alternative, we do
not consider using performance rather
than design standards to be consistent
with our statutory mandate of investor
protection with respect to preventing
fraudulent, deceptive, or manipulative
acts, or inappropriate sales practices,
conflicts of interest or compensation
schemes, by investment advisers.
G. Solicitation of Comments
We encourage written comments on
matters discussed in this IRFA. In
particular, the Commission seeks
comment on:
• The number of small entities that
would be affected by the proposed rule;
and
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• whether the effect of the proposed
rule on small entities would be
economically significant.
Commenters are asked to describe the
nature of any effect and provide
empirical data supporting the extent of
the effect.
VIII. Consideration of Impact on the
Economy
For purposes of the Small Business
Regulatory Enforcement Fairness Act of
1996, or ‘‘SBREFA,’’ 450 we must advise
OMB whether a proposed regulation
constitutes a ‘‘major’’ rule. Under
SBREFA, a rule is considered ‘‘major’’
where, if adopted, it results in or is
likely to result in (1) an annual effect on
the economy of $100 million or more;
(2) a major increase in costs or prices for
consumers or individual industries; or
(3) significant adverse effects on
competition, investment or innovation.
We request comment on the potential
impact of the proposed rules and
amendments on the economy on an
annual basis. Commenters are requested
to provide empirical data and other
factual support for their views to the
extent possible.
IX. Statutory Authority
The Commission is proposing new
rules 211(h)(1)–1, 211(h)(1)–2,
211(h)(2)–1, 211(h)(2)–2, 211(h)(2)–3,
and 206(4)–10 under the Advisers Act
under the authority set forth in sections
203(d), 206(4), 211(a), and 211(h) of the
Investment Advisers Act of 1940 [15
U.S.C. 80b–3(d), 80b–6(4) and 80b–11(a)
and (h)]. The Commission is proposing
amendments to rule 204–2 under the
Advisers Act under the authority set
forth in sections 204 and 211 of the
Investment Advisers Act of 1940 [15
U.S.C. 80b–4 and 80b–11]. The
Commission is proposing amendments
to rule 206(4)–7 under the Advisers Act
under the authority set forth in sections
203(d), 206(4), and 211(a) of the
Investment Advisers Act of 1940 [15
U.S.C. 80b–3(d), 80b–6(4), and 80b–
11(a)].
List of Subjects in 17 CFR Part 275
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Administrative practice and
procedure, Reporting and recordkeeping
requirements, Securities.
Text of Proposed Rules
For the reasons set forth in the
preamble, the Commission is proposing
to amend title 17, chapter II of the Code
of Federal Regulations as follows:
450 Public Law 104–121, Title II, 110 Stat. 857
(1996) (codified in various sections of 5 U.S.C., 15
U.S.C. and as a note to 5 U.S.C. 601).
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PART 275—RULES AND
REGULATIONS, INVESTMENT
ADVISERS ACT OF 1940
1. The authority citation for part 275
continues to read in part as follows:
■
Authority: 15 U.S.C. 80b–2(a)(11)(G), 80b–
2(a)(11)(H), 80b–2(a)(17), 80b–3, 80b–4, 80b–
4a, 80b–6(4), 80b–6a, and 80b–11, unless
otherwise noted.
*
*
*
*
*
Section 275.204–2 is also issued under 15
U.S.C. 80b–6.
*
*
*
*
*
2. Amend § 275.204–2 by:
a. Removing the period at the end of
paragraph (a)(7)(iv)(B) and adding ‘‘;
and’’ in its place; and
■ b. Adding paragraphs (a)(7)(v) and
(a)(20) through (23).
The additions read as follows:
■
■
§ 275.204–2 Books and records to be
maintained by investment advisers.
(a) * * *
(7) * * *
(v) Any notice required pursuant to
§ 275.211(h)(2)–3 as well as a record of
each addressee and the corresponding
date(s) sent, address(es), and delivery
method(s) for each such addressee.
*
*
*
*
*
(20)(i) A copy of any quarterly
statement distributed pursuant to
§ 275.211(h)(1)–2, along with a record of
each addressee and the corresponding
date(s) sent, address(es), and delivery
method(s) for each such addressee; and
(ii) All records evidencing the
calculation method for all expenses,
payments, allocations, rebates, offsets,
waivers, and performance listed on any
statement delivered pursuant to § 275.
211(h)(1)–2.
(21) For each private fund client:
(i) A copy of any audited financial
statements prepared and distributed
pursuant to § 275.206(4)–10, along with
a record of each addressee and the
corresponding date(s) sent, address(es),
and delivery method(s) for each such
addressee; or
(ii) A record documenting steps taken
by the adviser to cause a private fund
client that the adviser does not control,
is not controlled by, and with which it
is not under common control to undergo
a financial statement audit pursuant to
§ 275.206(4)–10.
(22) Documentation substantiating the
adviser’s determination that a private
fund client is a liquid fund or an illiquid
fund pursuant to § 275. 211(h)(1)–2.
(23) A copy of any fairness opinion
and material business relationship
summary distributed pursuant to
§ 275.211(h)(2)–2, along with a record of
each addressee and the corresponding
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date(s) sent, address(es), and delivery
method(s) for each such addressee.
*
*
*
*
*
■ 3. Amend § 275.206(4)–7 by revising
paragraph (b) to read as follows:
§ 275.206(4)–7 Compliance procedures
and practices.
*
*
*
*
*
(b) Annual review. Review and
document in writing, no less frequently
than annually, the adequacy of the
policies and procedures established
pursuant to this section and the
effectiveness of their implementation;
and
*
*
*
*
*
■ 4. Section 275.206(4)–10 is added to
read as follows:
§ 275.206(4)–10
audits.
Private fund adviser
As a means reasonably designed to
prevent such acts, practices, and courses
of business as are fraudulent, deceptive,
or manipulative, an investment adviser
that is registered or required to be
registered under section 203 of the
Investment Advisers Act of 1940 shall
cause each private fund that it advises,
directly or indirectly, to undergo a
financial statement audit as follows at
least annually and upon liquidation, if
the private fund does not otherwise
undergo such an audit:
(a) The audit is performed by an
independent public accountant that meets
the standards of independence described in
17 CFR 210.2–01(b) and (c) [Rule 2–01(b) and
(c) of Regulation S–X] and that is registered
with, and subject to regular inspection as of
the commencement of the professional
engagement period, and as of each calendar
year-end, by, the Public Company
Accounting Oversight Board in accordance
with its rules;
(b) The audit meets the definition in 17
CFR 210.1–02(d) [Rule 1–02(d) of Regulation
S–X], the professional engagement period of
which shall begin and end as indicated in
Rule 2–01(f)(5) of Regulation S–X;
(c) Audited financial statements are
prepared in accordance with U.S. Generally
Accepted Accounting Principles (‘‘U.S.
GAAP’’) or, in the case of financial
statements of private funds organized under
non-U.S. law or that have a general partner
or other manager with a principal place of
business outside the United States (‘‘foreign
private funds’’), contain information
substantially similar to statements prepared
in accordance with U.S. GAAP and material
differences with U.S. GAAP are reconciled;
(d) Promptly after the completion of the
audit, the private fund’s audited financial
statements, which includes any
reconciliation to U.S. GAAP prepared for a
foreign private fund, including
supplementary U.S. GAAP disclosures, as
applicable, are distributed;
(e) Pursuant to a written agreement
between the independent public accountant
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and the adviser or the private fund, the
independent public accountant that
completes the audit notifies the Commission
by electronic means directed to the Division
of Examinations:
(1) Promptly upon issuing an audit report
to the private fund that contains a modified
opinion; and
(2) Within four business days of
resignation or dismissal from, or other
termination of, the engagement, or upon
removing itself or being removed from
consideration for being reappointed;
(f) For a private fund that the adviser does
not control and is neither controlled by nor
under common control with, the adviser is
prohibited from providing investment advice,
directly or indirectly, to the private fund if
the adviser fails to take all reasonable steps
to cause the private fund to undergo a
financial statement audit that meets the
requirements of paragraphs (a) through (e) of
this section; and
(g) For purposes of this section, defined
terms shall have the meanings set forth in
§ 275.211(h)(1)–1.
5. Section 275.211(h)(1)–1 is added to
read as follows:
■
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§ 275.211(h)(1)–1
Definitions.
For purposes of §§ 275.206(4)–10,
275.211(h)(1)–2, 275.211(h)(2)–3,
275.211(h)(2)–1, and 275.211(h)(2)–2:
Adviser clawback means any
obligation of the adviser, its related
persons, or their respective owners or
interest holders to restore or otherwise
return performance-based
compensation to the private fund
pursuant to the private fund’s governing
agreements.
Adviser-led secondary transaction
means any transaction initiated by the
investment adviser or any of its related
persons that offers private fund
investors the choice to:
(1) Sell all or a portion of their
interests in the private fund; or
(2) Convert or exchange all or a
portion of their interests in the private
fund for interests in another vehicle
advised by the adviser or any of its
related persons.
Committed capital means any
commitment pursuant to which a
person is obligated to acquire an interest
in, or make capital contributions to, the
private fund.
Control means the power, directly or
indirectly, to direct the management or
policies of a person, whether through
ownership of securities, by contract, or
otherwise. For the purposes of this
definition, control includes:
(1) Each of an investment adviser’s
officers, partners, or directors exercising
executive responsibility (or persons
having similar status or functions) is
presumed to control the investment
adviser;
(2) A person is presumed to control a
corporation if the person:
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(i) Directly or indirectly has the right
to vote 25% or more of a class of the
corporation’s voting securities; or
(ii) Has the power to sell or direct the
sale of 25% or more of a class of the
corporation’s voting securities;
(3) A person is presumed to control a
partnership if the person has the right
to receive upon dissolution, or has
contributed, 25% or more of the capital
of the partnership;
(4) A person is presumed to control a
limited liability company if the person:
(i) Directly or indirectly has the right
to vote 25% or more of a class of the
interests of the limited liability
company;
(ii) Has the right to receive upon
dissolution, or has contributed, 25% or
more of the capital of the limited
liability company; or
(iii) Is an elected manager of the
limited liability company; or
(5) A person is presumed to control a
trust if the person is a trustee or
managing agent of the trust.
Covered portfolio investment means a
portfolio investment that allocated or
paid the investment adviser or its
related persons portfolio investment
compensation during the reporting
period.
Distribute, distributes, or distributed
means send or sent to all of the private
fund’s investors; provided that, if an
investor is a pooled investment vehicle
that is controlling, controlled by, or
under common control with (a ‘‘control
relationship’’) the adviser or its related
persons, the adviser must look through
that pool (and any pools in a control
relationship with the adviser or its
related persons) in order to send to
investors in those pools.
Fairness opinion means a written
opinion stating that the price being
offered to the private fund for any assets
being sold as part of an adviser-led
secondary transaction is fair.
Fund-level subscription facilities
means any subscription facilities,
subscription line financing, capital call
facilities, capital commitment facilities,
bridge lines, or other indebtedness
incurred by the private fund that is
secured by the unfunded capital
commitments of the private fund’s
investors.
Gross IRR means an internal rate of
return that is calculated gross of all fees,
expenses, and performance-based
compensation borne by the private
fund.
Gross MOIC means a multiple of
invested capital that is calculated gross
of all fees, expenses, and performancebased compensation borne by the
private fund.
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Illiquid fund means a private fund
that:
(1) Has a limited life;
(2) Does not continuously raise
capital;
(3) Is not required to redeem interests
upon an investor’s request;
(4) Has as a predominant operating
strategy the return of the proceeds from
disposition of investments to investors;
(5) Has limited opportunities, if any,
for investors to withdraw before
termination of the fund; and
(6) Does not routinely acquire
(directly or indirectly) as part of its
investment strategy market-traded
securities and derivative instruments.
Independent opinion provider means
an entity that:
(1) Provides fairness opinions in the
ordinary course of its business; and
(2) Is not a related person of the
adviser.
Internal rate of return means the
discount rate that causes the net present
value of all cash flows throughout the
life of the fund to be equal to zero.
Liquid fund means a private fund that
is not an illiquid fund.
Multiple of invested capital means, as
of the end of the applicable calendar
quarter:
(1) The sum of:
(i) The unrealized value of the illiquid
fund; and
(ii) The value of all distributions
made by the illiquid fund;
(2) Divided by the total capital
contributed to the illiquid fund by its
investors.
Net IRR means an internal rate of
return that is calculated net of all fees,
expenses, and performance-based
compensation borne by the private
fund.
Net MOIC means a multiple of
invested capital that is calculated net of
all fees, expenses, and performancebased compensation borne by the
private fund.
Performance-based compensation
means allocations, payments, or
distributions of capital based on the
private fund’s (or its portfolio
investments’) capital gains and/or
capital appreciation.
Portfolio investment means any entity
or issuer in which the private fund has
directly or indirectly invested.
Portfolio investment compensation
means any compensation, fees, and
other amounts allocated or paid to the
investment adviser or any of its related
persons by the portfolio investment
attributable to the private fund’s interest
in such portfolio investment, including,
but not limited to, origination,
management, consulting, monitoring,
servicing, transaction, administrative,
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advisory, closing, disposition, directors,
trustees or similar fees or payments.
Related person means:
(1) All officers, partners, or directors
(or any person performing similar
functions) of the adviser;
(2) All persons directly or indirectly
controlling or controlled by the adviser;
(3) All current employees (other than
employees performing only clerical,
administrative, support or similar
functions) of the adviser; and
(4) Any person under common control
with the adviser.
Reporting period means the private
fund’s calendar quarter covered by the
quarterly statement or, for the initial
quarterly statement of a newly formed
private fund, the period covering the
private fund’s first two full calendar
quarters of operating results.
Statement of Contributions and
Distributions means a document that
presents:
(1) All capital inflows the private
fund has received from investors and all
capital outflows the private fund has
distributed to investors since the private
fund’s inception, with the value and
date of each inflow and outflow; and
(2) The net asset value of the private
fund as of the end of the reporting
period.
Substantially similar pool of assets
means a pooled investment vehicle
(other than an investment company
registered under the Investment
Company Act of 1940 or a company that
elects to be regulated as such) with
substantially similar investment
policies, objectives, or strategies to those
of the private fund managed by the
investment adviser or its related
persons.
Unfunded capital commitments
means committed capital that has not
yet been contributed to the private fund
by investors.
■ 6. Section 275.211(h)(1)–2 is added to
read as follows:
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§ 275. 211(h)(1)–2
statements.
Private fund quarterly
(a) Quarterly statements. As a means
reasonably designed to prevent such
acts, practices, and courses of business
as are fraudulent, deceptive, or
manipulative, an investment adviser
that is registered or required to be
registered under section 203 of the
Investment Advisers Act of 1940 shall
prepare a quarterly statement that
complies with paragraphs (a) through (g)
of this section for any private fund that
it advises, directly or indirectly, that has
at least two full calendar quarters of
operating results, and distribute the
quarterly statement to the private fund’s
investors within 45 days after each
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calendar quarter end, unless such a
quarterly statement is prepared and
distributed by another person.
(b) Fund table. The quarterly
statement must include a table for the
private fund that discloses, at a
minimum, the following information,
presented both before and after the
application of any offsets, rebates, or
waivers for the information required by
paragraphs (b)(1) and (2) of this section:
(1) A detailed accounting of all
compensation, fees, and other amounts
allocated or paid to the investment
adviser or any of its related persons by
the fund during the reporting period,
with separate line items for each
category of allocation or payment
reflecting the total dollar amount,
including, but not limited to,
management, advisory, sub-advisory, or
similar fees or payments, and
performance-based compensation;
(2) A detailed accounting of all fees
and expenses paid by the private fund
during the reporting period (other than
those listed in paragraph (b)(1) of this
section), with separate line items for
each category of fee or expense
reflecting the total dollar amount,
including, but not limited to,
organizational, accounting, legal,
administration, audit, tax, due
diligence, and travel fees and expenses;
and
(3) The amount of any offsets or
rebates carried forward during the
reporting period to subsequent periods
to reduce future payments or allocations
to the adviser or its related persons.
(c) Portfolio investment table. The
quarterly statement must include a
separate table for the private fund’s
covered portfolio investments that
discloses, at a minimum, the following
information for each covered portfolio
investment:
(1) A detailed accounting of all
portfolio investment compensation
allocated or paid to the investment
adviser or any of its related persons by
the covered portfolio investment during
the reporting period, with separate line
items for each category of allocation or
payment reflecting the total dollar
amount, presented both before and after
the application of any offsets, rebates, or
waivers; and
(2) The fund’s ownership percentage
of each such covered portfolio
investment as of the end of the reporting
period, or zero, if the fund does not have
an ownership interest in the covered
portfolio investment, along with a brief
description of the fund’s investment.
(d) Calculations and cross references.
The quarterly statement must include
prominent disclosure regarding the
manner in which all expenses,
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payments, allocations, rebates, waivers,
and offsets are calculated and include
cross references to the sections of the
private fund’s organizational and
offering documents that set forth the
applicable calculation methodology.
(e) Performance. (1) No later than the
time the adviser sends the initial
quarterly statement, the adviser must
determine that the private fund is an
illiquid fund or a liquid fund.
(2) The quarterly statement must
present the following with equal
prominence:
(i) Liquid funds. For a liquid fund:
(A) Annual net total returns for each
calendar year since inception;
(B) Average annual net total returns
over the one-, five-, and ten- calendar
year periods; and
(C) The cumulative net total return for
the current calendar year as of the end
of the most recent calendar quarter
covered by the quarterly statement.
(ii) Illiquid funds. For an illiquid
fund:
(A) The following performance
measures, shown since inception of the
illiquid fund through the end of the
quarter covered by the quarterly
statement (or, to the extent quarter-end
numbers are not available at the time
the adviser distributes the quarterly
statement, through the most recent
practicable date) and computed without
the impact of any fund-level
subscription facilities:
(1) Gross IRR and gross MOIC for the
illiquid fund;
(2) Net IRR and net MOIC for the
illiquid fund;
(3) Gross IRR and gross MOIC for the
realized and unrealized portions of the
illiquid fund’s portfolio, with the
realized and unrealized performance
shown separately; and
(4) A statement of contributions and
distributions for the illiquid fund.
(B) [Reserved]
(iii) The quarterly statement must
include the date as of which the
performance information is current
through and prominent disclosure of the
criteria used and assumptions made in
calculating the performance.
(f) Consolidated reporting. To the
extent doing so would provide more
meaningful information to the private
fund’s investors and would not be
misleading, the adviser must
consolidate the reporting required by
paragraphs (a) through (e) of this section
to cover substantially similar pools of
assets.
(g) Format and content. The quarterly
statement must use clear, concise, plain
English and be presented in a format
that facilitates review from one
quarterly statement to the next.
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(h) Definitions. For purposes of this
section, defined terms shall have the
meanings set forth in § 275.211(h)(1)–1.
■ 7. Section 275.211(h)(2)–1 is added to
read as follows:
§ 275.211(h)(2)–1 Private fund adviser
prohibited activities.
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(a) An investment adviser to a private
fund may not, directly or indirectly, do
the following with respect to the private
fund, or any investor in that private
fund:
(1) Charge a portfolio investment for
monitoring, servicing, consulting, or
other fees in respect of any services that
the investment adviser does not, or does
not reasonably expect to, provide to the
portfolio investment;
(2) Charge the private fund for fees or
expenses associated with an
examination or investigation of the
adviser or its related persons by any
governmental or regulatory authority;
(3) Charge the private fund for any
regulatory or compliance fees or
expenses of the adviser or its related
persons;
(4) Reduce the amount of any adviser
clawback by actual, potential, or
hypothetical taxes applicable to the
adviser, its related persons, or their
respective owners or interest holders;
(5) Seek reimbursement,
indemnification, exculpation, or
limitation of its liability by the private
fund or its investors for a breach of
fiduciary duty, willful misfeasance, bad
faith, negligence, or recklessness in
providing services to the private fund;
(6) Charge or allocate fees and
expenses related to a portfolio
investment (or potential portfolio
investment) on a non-pro rata basis
when multiple private funds and other
clients advised by the adviser or its
related persons have invested (or
propose to invest) in the same portfolio
investment; and
(7) Borrow money, securities, or other
private fund assets, or receive a loan or
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an extension of credit, from a private
fund client.
(b) For purposes of this section,
defined terms shall have the meanings
set forth in § 275.211(h)(1)–1.
■ 8. Section 275.211(h)(2)–2 is added to
read as follows:
§ 275.211(h)(2)–2
Adviser-led secondaries.
(a) As a means reasonably designed to
prevent fraudulent, deceptive, or
manipulative acts, practices, or courses
of business within the meaning of
section 206(4) of the Act (15 U.S.C. 80b–
6(4)), it is unlawful for any investment
adviser that is registered or required to
be registered under section 203 of the
Act to complete an adviser-led
secondary transaction with respect to
any private fund, unless the adviser:
(1) Obtains, and distributes to
investors in the private fund, a fairness
opinion from an independent opinion
provider; and
(2) Prepares, and distributes to
investors in the private fund, a written
summary of any material business
relationships the adviser or any of its
related persons has, or has had within
the past two years, with the
independent opinion provider, in each
case, prior to the closing of the adviserled secondary transaction.
(b) For purposes of this section,
defined terms shall have the meanings
set forth in § 275.211(h)(1)–1.
■ 9. Section 275.211(h)(2)–3 is added to
read as follows:
§ 275.211(h)(2)–3
Preferential treatment.
(a) An investment adviser to a private
fund may not, directly or indirectly, do
the following with respect to the private
fund, or any investor in that private
fund:
(1) Grant an investor in the private
fund or in a substantially similar pool
of assets the ability to redeem its
interest on terms that the adviser
reasonably expects to have a material,
negative effect on other investors in that
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16977
private fund or in a substantially similar
pool of assets; or
(2) Provide information regarding the
portfolio holdings or exposures of the
private fund, or of a substantially
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
substantially similar pool of assets.
(b) An investment adviser to a private
fund may not, directly or indirectly,
provide any other preferential treatment
to any investor in the private fund
unless the adviser provides written
notices as follows:
(1) Advance written notice for
prospective investors in a private fund.
The investment adviser shall provide to
each prospective investor in the private
fund, prior to the investor’s investment
in the private fund, a written notice that
provides specific information regarding
any preferential treatment the adviser or
its related persons provide to other
investors in the same private fund.
(2) Annual written notice for current
investors in a private fund. The
investment adviser shall distribute to
current investors, on at least an annual
basis, a written notice that provides
specific information regarding any
preferential treatment provided by the
adviser or its related persons to other
investors in the same private fund since
the last written notice provided in
accordance with this section, if any.
(c) For purposes of this section,
defined terms shall have the meanings
set forth in § 275.211(h)(1)–1.
By the Commission.
Dated: February 9, 2022.
Vanessa A. Countryman,
Secretary.
[FR Doc. 2022–03212 Filed 3–23–22; 8:45 am]
BILLING CODE 8011–01–P
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]]>Agencies
[Federal Register Volume 87, Number 57 (Thursday, March 24, 2022)]
[Proposed Rules]
[Pages 16886-16977]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2022-03212]
[[Page 16885]]
Vol. 87
Thursday,
No. 57
March 24, 2022
Part III
Securities and Exchange Commission
-----------------------------------------------------------------------
17 CFR Part 275
Private Fund Advisers; Documentation of Registered Investment Adviser
Compliance Reviews; Proposed Rule
Federal Register / Vol. 87, No. 57 / Thursday, March 24, 2022 /
Proposed Rules
[[Page 16886]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 275
[Release Nos. IA-5955; File No. S7-03-22]
RIN 3235-AN07
Private Fund Advisers; Documentation of Registered Investment
Adviser Compliance Reviews
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
-----------------------------------------------------------------------
SUMMARY: The Securities and Exchange Commission (the ``Commission'' or
the ``SEC'') is proposing new rules under the Investment Advisers Act
of 1940 (the ``Advisers Act'' or the ``Act''). We propose to require
registered investment advisers to private funds to provide transparency
to their investors regarding the full cost of investing in private
funds and the performance of such private funds. We also are proposing
rules that would require a registered private fund adviser to obtain an
annual financial statement audit of each private fund it advises and,
in connection with an adviser-led secondary transaction, a fairness
opinion from an independent opinion provider. In addition, we are
proposing rules that would prohibit all private fund advisers,
including those that are not registered with the Commission, from
engaging in certain sales practices, conflicts of interest, and
compensation schemes that are contrary to the public interest and the
protection of investors. All private fund advisers would also be
prohibited from providing preferential treatment to certain investors
in a private fund, unless the adviser discloses such treatment to other
current and prospective investors. We are proposing corresponding
amendments to the Advisers Act books and records rule to facilitate
compliance with these proposed new rules and assist our examination
staff. Finally, we are proposing amendments to the Advisers Act
compliance rule, which would affect all registered investment advisers,
to better enable our staff to conduct examinations.
DATES: Comments should be received on or before April 25, 2022.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's internet comment form (https://www.sec.gov/rules/submitcomments.htm); or
Send an email to [email protected]. Please include
File Number S7-03-22 on the subject line.
Paper Comments
Send paper comments to Vanessa A. Countryman, Secretary,
Securities and Exchange Commission, 100 F Street NE, Washington, DC
20549-1090.
All submissions should refer to File Number S7-03-22. This file number
should be included on the subject line if email is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
website (https://www.sec.gov/rules/proposed.shtml). Comments are also
available for website viewing and printing in the Commission's Public
Reference Room, 100 F Street NE, Washington, DC 20549, on official
business days between the hours of 10:00 a.m. and 3:00 p.m. Operating
conditions may limit access to the Commission's public reference room.
All comments received will be posted without change; we do not edit
personal identifying information from submissions. You should submit
only information that you wish to make available publicly.
Studies, memoranda, or other substantive items may be added by the
Commission or staff to the comment file during this rulemaking. A
notification of the inclusion in the comment file of any such materials
will be made available on the Commission's website. To ensure direct
electronic receipt of such notifications, sign up through the ``Stay
Connected'' option at www.sec.gov to receive notifications by email.
FOR FURTHER INFORMATION CONTACT: Christine Schleppegrell, Senior
Counsel; Thomas Strumpf, Senior Counsel; Melissa Roverts Harke, Senior
Special Counsel; Michael C. Neus, Private Funds Attorney Fellow; or
Melissa S. Gainor, Assistant Director, Investment Adviser Rulemaking
Office, or Marc Mehrespand, Branch Chief, Chief Counsel's Office, at
(202) 551-6787 or [email protected], Division of Investment Management,
Securities and Exchange Commission, 100 F Street NE, Washington, DC
20549-8549.
SUPPLEMENTARY INFORMATION: The Securities and Exchange Commission (the
``Commission'') is proposing for public comment 17 CFR 275.206(4)-10
(new rule 206(4)-10), 17 CFR 275.211(h)(1)-1 (new rule 211(h)(1)-1), 17
CFR 275.211(h)(1)-2 (new rule 211(h)(1)-2), 17 CFR 275.211(h)(2)-1 (new
rule 211(h)(2)-1), 17 CFR 275.211(h)(2)-2 (new rule 211(h)(2)-2), and
17 CFR 275.211(h)(2)-3 (new rule 211(h)(2)-3) under the Investment
Advisers Act of 1940 [15 U.S.C. 80b-1 et seq.] (the ``Advisers Act'');
\1\ and amendments to 17 CFR 275.204-2 (rule 204-2) and 17 CFR
275.206(4)-7 (rule 206(4)-7) under the Advisers Act.
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\1\ Unless otherwise noted, when we refer to the Advisers Act,
or any section of the Advisers Act, we are referring to 15 U.S.C.
80b, at which the Advisers Act is codified. When we refer to rules
under the Advisers Act, or any section of those rules, we are
referring to title 17, part 275 of the Code of Federal Regulations
[17 CFR part 275], in which these rules are published.
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Table of Contents
I. Background and Need for Reform
II. Discussion of Proposed Rules for Private Fund Advisers
A. Quarterly Statements
1. Fee and Expense Disclosure
2. Performance Disclosure
3. Preparation and Distribution of Quarterly Statements
4. Consolidated Reporting for Certain Fund Structures
5. Format and Content Requirements
6. Recordkeeping for Quarterly Statements
B. Mandatory Private Fund Adviser Audits
1. Requirements for Accountants Performing Private Fund Audits
2. Auditing Standards for Financial Statements
3. Preparation of Audited Financial Statements
4. Prompt Distribution of Audited Financial Statements
5. Annual Audit, Liquidation Audit, and Audit Period Lengths
6. Commission Notification
7. Taking All Reasonable Steps To Cause an Audit
8. Recordkeeping Provisions Related to the Proposed Audit Rule
C. Adviser-Led Secondaries
1. Recordkeeping for Adviser-Led Secondaries
D. Prohibited Activities
1. Fees for Unperformed Services
2. Certain Fees and Expenses
3. Reducing Adviser Clawbacks for Taxes
4. Limiting or Eliminating Liability for Adviser Misconduct
5. Certain Non-Pro Rata Fee and Expense Allocations
6. Borrowing
E. Preferential Treatment
1. Recordkeeping for Preferential Treatment
III. Discussion of Proposed Written Documentation of All Advisers'
Annual Reviews of Compliance Programs
IV. Transition Period and Compliance Date
V. Economic Analysis
A. Introduction
B. Economic Baseline
1. Industry Statistics and Affected Parties
2. Sales Practices, Compensation Arrangements, and Other
Business Practices of Private Fund Advisers
3. Private Fund Adviser Fee, Expense, and Performance Disclosure
Practices
4. Fund Audits and Fairness Opinions
5. Books and Records
6. Documentation of Annual Review Under the Compliance Rule
[[Page 16887]]
C. Benefits and Costs
1. Overview and Broad Economic Considerations
2. Quarterly Statements
3. Prohibited Activities and Disclosure of Preferential
Treatment
4. Audits, Fairness Opinions, and Documentation of Annual Review
of Compliance Programs
5. Recordkeeping
D. Effects on Efficiency, Competition, and Capital Formation
1. Efficiency
2. Competition
3. Capital Formation
E. Alternatives Considered
1. Alternatives to the Requirement for Private Fund Advisers To
Obtain an Annual Audit
2. Alternatives to the Requirement To Distribute a Quarterly
Statement to Investors Disclosing Certain Information Regarding
Costs and Performance
3. Alternative to the Required Manner of Preparing and
Distributing Quarterly Statements and Audited Financial Statements
4. Alternatives to the Prohibitions From Engaging in Certain
Sales Practices, Conflicts of Interest, and Compensation Schemes
5. Alternatives to the Requirement That an Adviser To Obtain a
Fairness Opinion in Connection With Certain Adviser-Led Secondary
Transactions
6. Alternatives to the Prohibition From Providing Certain
Preferential Terms and Requirement To Disclose All Preferential
Treatment
F. Request for Comment
VI. Paperwork Reduction Act
A. Introduction
B. Quarterly Statements
C. Mandatory Private Fund Adviser Audits
D. Adviser-Led Secondaries
E. Disclosure of Preferential Treatment
F. Written Documentation of Adviser's Annual Review of
Compliance Program
G. Recordkeeping
H. Request for Comment
VII. Initial Regulatory Flexibility Analysis
A. Reasons for and Objectives of the Proposed Action
1. Proposed Rule 211(h)(1)-1
2. Proposed Rule 211(h)(1)-2
3. Proposed Rule 206(4)-10
4. Proposed Rule 211(h)(2)-1
5. Proposed Rule 211(h)(2)-2
6. Proposed Rule 211(h)(2)-3
7. Proposed Amendments to Rule 204-2
8. Proposed Amendments to Rule 206(4)-(7)
B. Legal Basis
C. Small Entities Subject to Rules
D. Projected Reporting, Recordkeeping, and Other Compliance
Requirements
1. Proposed Rule 211(h)(1)-1
2. Proposed Rule 211(h)(1)-2
3. Proposed Rule 206(4)-10
4. Proposed Rule 211(h)(2)-1
5. Proposed Rule 211(h)(2)-2
6. Proposed Rule 211(h)(2)-3
7. Proposed Amendments to Rule 204-2
8. Proposed Amendments to Rule 206(4)-(7)
E. Duplicative, Overlapping, or Conflicting Federal Rules
F. Significant Alternatives
G. Solicitation of Comments
VIII. Consideration of Impact on the Economy
IX. Statutory Authority
I. Background and Need for Reform
In the wake of the 2007-2008 financial crisis, Congress passed and
the President signed the Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010 (``Dodd-Frank Act''), which increased the
Commission's oversight responsibility for private fund advisers.\2\
Among other things, the Dodd-Frank Act amended the Advisers Act
generally to require advisers to private funds to register with the
Commission and to require the Commission to establish reporting and
recordkeeping requirements for advisers to private funds for investor
protection and systemic risk purposes.\3\ The Dodd-Frank Act also added
section 211(h) to the Advisers Act, which, among other things, directs
the Commission to ``facilitate the provision of simple and clear
disclosures to investors regarding the terms of their relationships
with . . . investment advisers'' and ``promulgate rules prohibiting or
restricting certain sales practices, conflicts of interest, and
compensation schemes for investment advisers.'' \4\
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\2\ Section 202(a)(29) of the Advisers Act defines the term
``private fund'' as an issuer that would be an investment company,
as defined in section 3 of the Investment Company Act of 1940 (15
U.S.C. 80a-3) (``Investment Company Act''), but for section 3(c)(1)
or 3(c)(7) of that Act. We use ``private fund'' and ``fund''
interchangeably throughout this release.
\3\ See, e.g., Rule Implementing Amendments to the Investment
Advisers Act of 1940, Investment Advisers Act Release No. 3221 (June
22, 2011) (``Implementing Release''); Reporting by Investment
Advisers to Private Funds and Certain Commodity Pool Operators and
Commodity Trading Advisors on Form PF, Investment Advisers Act
Release No. 3308 (Oct. 31, 2011).
\4\ Dodd-Frank Wall Street Reform and Consumer Protection Act,
section 913(h), Public Law 111-203, 124 Stat. 1376 (2010).
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Registration and reporting on both Form ADV and Form PF have been
critical to increasing transparency and protecting investors in private
funds and assessing systemic risk.\5\ They also have substantially
improved our ability to understand private fund advisers' operations
and relationships with investors as private funds play an increasingly
important role in the financial system and private funds continue
growing in size, complexity, and number. There are currently 5,037
registered private fund advisers with over $18 trillion in private fund
assets under management.\6\ In addition, private funds and their
advisers play an increasing role in the economy. For example, hedge
funds engage in trillions of dollars in listed equity and futures
transactions each month.\7\ Private equity and other private funds are
involved in mergers and acquisitions, non-bank lending, and
restructurings and bankruptcies. Venture capital funds provide funding
to start-ups and early stage companies. Private funds and their
advisers also play an increasingly important role in the lives of
everyday Americans saving for retirement or college tuition. Some of
the largest groups of private fund investors include state and
municipal pension plans, college and university endowments, non-profit
organizations, and high net worth individuals.\8\ Numerous investors
also have indirect exposure to private funds through private pension
plans, endowments, feeder funds established by banks and other
financial institutions, foundations, and certain other retirement
plans.
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\5\ The Financial Stability Oversight Council uses these and
other tools to assess private fund impact on systemic risk. See also
U.S. Securities and Exchange Commission, Division of Investment
Management, Analytics Office, Private Fund Statistics, available at
https://www.sec.gov/divisions/investment/private-funds-statistics.shtml (providing a summary of private fund industry
statistics and trends based on data collected through Form PF and
Form ADV). Staff reports, statistics, and other staff documents
(including those cited herein) represent the views of Commission
staff and are not a rule, regulation, or statement of the
Commission. The Commission has neither approved nor disapproved the
content of these documents and, like all staff statements, they have
no legal force or effect, do not alter or amend applicable law, and
create no new or additional obligations for any person. The
Commission has expressed no view regarding the analysis, findings,
or conclusions contained therein.
\6\ Form ADV data current as of November 30, 2021.
\7\ See Division of Investment Management: Analytics Office,
Private Funds Statistics Report: First Calendar Quarter 2021 (Nov.
1, 2021) (``Form PF Statistics Report''), at 31, available at
https://www.sec.gov/divisions/investment/private-funds-statistics/private-funds-statistics-2021-q1.pdf (showing aggregate portfolio
turnover for hedge funds managed by large hedge fund advisers (i.e.,
advisers with at least $1.5 billion in hedge fund assets under
management) as reported on Form PF).
\8\ See Form PF Statistics Report, supra at footnote 7, at 15
(showing beneficial ownership of all funds by category as reported
on Form PF). See also, e.g., Public Investors, Private Funds, and
State Law, Baylor Law Review, Professor William Clayton (June 15,
2020) (``Professor Clayton Article''), at 354 (noting that public
pension plans have dramatically increased their investment in
private funds).
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During our decade overseeing most private fund advisers, our staff
has examined private fund advisers to assess both the issues and risks
presented by their business models and the firms' compliance with their
existing legal obligations.\9\ The
[[Page 16888]]
Commission also has pursued enforcement actions against private fund
advisers for practices that have caused private funds to pay more in
fees and expenses than they should have, which negatively affected
returns for private fund investors, or resulted in investors not being
informed of relevant conflicts of interest concerning the private fund
adviser and the fund.\10\ Despite our examination and enforcement
efforts, these activities persist.\11\
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\9\ See, e.g., OCIE National Examination Program Risk Alert:
Observations from Examinations of Investment Advisers Managing
Private Funds (June 23, 2020) (``EXAMS Private Funds Risk Alert
2020''), available at https://www.sec.gov/files/Private%20Fund%20Risk%20Alert_0.pdf. As of December 17, 2020, the
Office of Compliance, Inspections and Examinations (``OCIE'') was
renamed the Division of Examinations (``EXAMS'').
\10\ See, e.g., In re Kohlberg Kravis Roberts & Co. L.P.,
Investment Advisers Act Release No. 4131 (June 29, 2015) (settled
action) (alleging private fund adviser misallocated more than $17
million in so-called ``broken deal'' expenses to its flagship
private equity fund); In re Blackstone Management Partners L.L.C.,
et al., Investment Advisers Act Release No. 4219 (Oct. 7, 2015)
(settled action) (alleging private fund advisers failed to inform
investors about benefits that the advisers obtained from accelerated
monitoring fees and discounts on legal fees); In re NB Alternatives
Advisers LLC, Investment Advisers Act Release No. 5079 (Dec. 17,
2018) (settled action) (alleging private fund adviser improperly
allocated approximately $2 million of compensation-related expenses
to three private equity funds it advised).
\11\ See, e.g., In the Matter of Diastole Wealth Management,
Inc., Investment Advisers Act Release No. 5855 (Sept. 10, 2021)
(settled action) (alleging private fund adviser failed to disclose
to investors that the adviser periodically made loans to a company
owned by the son of the principal of the advisory firm and that the
private fund's investment in the company could be used to repay the
loans made by the adviser); In re Global Infrastructure Management,
LLC, Investment Advisers Act Release No. 5930 (Dec. 20, 2021)
(settled action) (alleging private fund adviser failed to properly
offset management fees to private equity funds it managed and made
false and misleading statements to investors and potential investors
in those funds concerning management fee offsets); In the Matter of
EDG Management Company, LLC, Investment Advisers Act Release No.
5617 (Oct. 22, 2020) (settled action) (alleging that private equity
fund adviser failed to apply the management fee calculation method
specified in the limited partnership agreement by failing to account
for write downs of portfolio securities causing the fund and
investors to overpay management fees); In the Matter of Mitchell J.
Friedman, Investment Advisers Act Release No. 5338 (Sept. 4, 2019)
(settled action) (alleging that the co-owner of a private fund
advisory firm failed to disclose material conflicts of interest to
the private fund it managed and misled two investors by
misrepresenting an investment opportunity).
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First, we continue to observe that private fund investments are
often opaque; advisers frequently do not provide investors with
sufficiently detailed information about private fund investments.
Without sufficiently clear, comparable information, even sophisticated
investors would be unable to protect their interests or make sound
investment decisions. For example, some investors do not have
sufficient information regarding private fund or portfolio company fees
and expenses to make informed investment decisions, given those fees
and expenses can be subject to complicated calculation methodologies
(that often include the application of offsets, waivers, and other
limits); may have varied labels across private funds; and can affect
individual investors' returns differently because of alternative fee
arrangements set forth in side letter agreements. In addition, advisers
often provide private fund investors with laundry lists of potential
fees and expenses, without giving details on the magnitude and scope of
fees and expenses charged. Beyond management fees, performance-based
compensation, and the expenses charged directly to the funds, some
private fund advisers and their related persons charge a number of fees
and expenses to the fund's portfolio companies. These can include
consulting fees, monitoring fees, servicing fees, transaction fees,
director's fees, and others. At the time of the initial investment and
as fund operations continue, many investors do not have sufficient
information regarding these fee streams that flow to the adviser or its
related persons and reduce the return on their investment.
Investors also often lack sufficient transparency into how private
fund performance is calculated. Advisers frequently present fund
performance reflecting different assumptions, making it difficult to
measure and compare data across funds and advisers or compare the
fund's performance to the investor's chosen benchmarks, even where the
assumptions are disclosed. For example, one adviser may show fund
performance that reflects the use of a subscription line of credit
initially to fund investments and pay expenses rather than investor
capital. Another adviser may present only unlevered performance results
that do not reflect the effect of a subscription line. More
standardized requirements for performance metrics would allow private
fund investors to make apples to apples comparisons when assessing the
returns of similar fund strategies over different market environments
and over time. More standardized requirements for performance
information also would improve investors' ability to interpret complex
performance reporting, and assess the relationship between the fees
paid in connection with an investment and the return on that investment
as they monitor their investment and consider potential future
investments.
Similarly, investors may not have information regarding the
preferred terms granted to certain investors (e.g., seed investors,
strategic investors, those with large commitments, and employees,
friends, and family). Advisers frequently grant preferred terms to
certain investors that often are not attainable for smaller
institutional investors or individual investors. In some cases, these
terms materially disadvantage other investors in the private fund.\12\
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\12\ See, e.g., Securities and Exchange Commission v. Philip A.
Falcone, Harbinger Capital Partners Offshore Manager, L.L.C. and
Harbinger Capital Partners Special Situations GP, L.L.C., Civil
Action No. 12 Civ. 5027 (PAC) (S.D.N.Y.) and Securities and Exchange
Commission v. and (sic) Harbinger Capital Partners LLC, Philip A.
Falcone and Peter A. Jenson, Civil Action No. 12 Civ. 5028 (PAC)
(S.D.N.Y.), Civil Action No. 12 Civ. 5027 (PAC) (S.D.N.Y.), U.S.
Securities and Exchange Commission Litigation Release No. 22831A
(Oct. 2, 2013) (``Harbinger Capital'') (private fund adviser granted
favorable redemption and liquidity terms to certain large investors
in a private fund without disclosing these arrangements to the
fund's board of directors and the other fund investors). See also 17
CFR 275.206(4)-8 (rule 206(4)-8 under the Advisers Act).
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This lack of transparency regarding costs, performance, and
preferential terms causes an information imbalance between advisers and
private fund investors, which, in many cases, prevents private
bilateral negotiations from effectively remedying shortcomings in the
private funds market. We believe that this imbalance serves only the
adviser's interest and leaves many investors without the tools they
need to effectively protect their interests, whether through
negotiations or otherwise. Moreover, certain advisers may only provide
sufficiently detailed information following an investor's admission to
the fund when the primary bargaining window has closed, particularly
for closed-end funds where investors have no, or very limited, options
to withdraw.
Enhanced information about costs, performance, and preferential
treatment, would help an investor better decide whether to invest or to
remain invested in a particular private fund, how to invest other
assets in the investor's portfolio, and whether to invest in private
funds managed by the adviser or its related persons in the future. More
standardized information would improve comparability among private
funds with similar characteristics. This information also would help a
private fund investor better monitor and assess the true cost of its
investments, the value of the services for which the fund is paying,
and potential conflicts of interest. For example, enhanced cost
information could allow an investor to identify when the private fund
has incorrectly, or improperly, assessed a fee or expense by the
adviser contrary to the adviser's fiduciary duty, contractual
obligations to the fund, or
[[Page 16889]]
disclosures by the fund or the adviser. Ultimately, this information
would help investors better understand marketplace dynamics and
potentially improve efficiency for future investments, for example, by
expediting the process for reviewing and negotiating fees and expenses.
More competition and transparency also could lower the costs of capital
for portfolio companies raising money and increase returns to
investors, potentially bringing greater efficiencies to this part of
the capital markets.
We also have continued to observe instances of advisers acting on
conflicts of interest that are not transparent to investors, provide
substantial financial benefits to the adviser, and potentially have
significant negative impacts on the private fund's returns.\13\ These
issues are widespread in the private fund context because, in many
cases, the adviser can influence or control the portfolio company and
can extract compensation without the knowledge of the fund or its
investors. In addition, private funds typically lack governance
mechanisms that would help check overreaching by private fund advisers.
For example, although some private funds may have limited partner
advisory committees (``LPACs'') or boards of directors, these types of
bodies may not have the necessary independence, authority, or
accountability to oversee and consent to these conflicts or other
harmful practices. Private funds also do not have comprehensive
mechanisms for private fund investors to exercise effective governance,
which is exacerbated by the fact that private fund advisers often
provide certain investors with preferential terms that can create
potential conflicts among the fund's investors. Moreover, the interests
of one or more private fund investors may not represent the interests
of, or may otherwise conflict with the interests of, other investors in
the private fund due to, among other things, business or personal
relationships or other private fund investments. To the extent
investors are afforded governance or similar rights, such as LPAC
representation, certain fund agreements permit such investors to
exercise their rights in a manner that places their interests ahead of
the private fund or the investors as a whole. For example, certain fund
agreements state that, subject to applicable law, LPAC members owe no
duties to the private fund or to any of the other investors in the
private fund and are not obligated to act in the interests of the
private fund or the other investors as a whole.
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\13\ See, e.g., In the Matter of Bluecrest Capital Management
Limited, Investment Advisers Act Release No. 5642 (Dec. 8, 2020)
(settled action) (alleging that hedge fund adviser strategically re-
allocated its best performing personnel (traders) from its flagship
hedge fund to its proprietary hedge fund, which followed an
overlapping trading strategy and that hedge fund adviser failed to
adequately disclose the existence of its proprietary hedge fund, the
movement of traders, and related conflicts of interest); In the
Matter of Monomoy Capital Management, L.P., Investment Advisers Act
Release No. 5485 (Apr. 22, 2020) (settled order) (alleging that
private fund adviser charged the fund's portfolio company for the
services of its in-house operations group without fulling disclosing
this practice).
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As an example of advisers acting on conflicts of interest, certain
venture capital fund advisers use private funds to obtain a controlling
or influential interest in a non-publicly traded early stage company
and then instruct that company to hire the adviser or its related
persons to provide certain services. In these circumstances, the
adviser often sets the terms of the engagement, including the price
paid for the services. In cases where the adviser causes the fund to
overpay for services because the services were not negotiated in an
arm's-length process, the adviser's practice of hiring its related
persons harms investors by diminishing the private fund's returns. For
example, the adviser sometimes instructs the company to pay certain of
the adviser's bills, to reimburse the adviser for expenses incurred in
managing its investment in the company, or to add to its payroll
adviser employees who manage the investment. In contrast, outside of
the private fund context, an adviser often uses private fund clients to
buy shares in a company and may vote proxies or engage with management
and the board, but absent taking some extraordinary steps, the
adviser's ability to influence or control the company is generally
constrained. In addition, if the company is publicly traded, the
adviser's attempts to seize control or make a variety of other changes
are generally visible to its clients and the public at large.
Although many conflicts of interest can involve problematic sales
practices or compensation schemes, some can be managed. For example,
advisers have a conflict of interest with private funds and investors
in those funds when they value the fund's assets and use that valuation
as the basis for the calculation of the adviser's fees and fund
performance.\14\ Similarly, advisers or their related persons have a
conflict of interest with the fund and its investors when they offer
existing fund investors the option to sell or exchange their interests
in the private fund for interests in another vehicle advised by the
adviser or any of its related persons (an ``adviser-led secondary
transaction''). In both of these examples, there are opportunities for
advisers, funds, and investors to benefit, but there is also a
potential for significant harm if the adviser's conflicts are not
appropriately handled, including diminishing the fund's returns because
of excess fees and expenses paid to the fund's adviser or its related
persons. In these cases, enhanced protections in the form of an annual
private fund audit and a fairness opinion in connection with an
adviser-led secondary transaction would help address the concerns
presented by these conflicts.
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\14\ See, e.g., SEC v. Joseph W. Daniel, Litigation Release No.
19427 (Oct. 13, 2005) and In re Joseph W. Daniel, Investment
Advisers Act Release No. 2450 (Nov. 29, 2005) (settled action)
(alleging adviser failed to properly value holdings of its hedge
fund client, which inflated the management fees investor paid); In
the Matter of Swapnil Rege, Investment Advisers Act Release No. 5303
(July 18, 2019) (settled action) (alleging that an employee of a
private fund adviser mispriced the private fund's investments, which
resulted in the adviser charging the fund excess management fees).
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Other conflicts of interest are contrary to the public interest and
the protection of investors, and cannot be managed given the lack of
governance mechanisms frequent in private funds as discussed above. For
example, we have observed situations where the adviser causes one fund
to bear more than its pro rata share of expenses related to a portfolio
investment.\15\ In these circumstances, an adviser may unfairly
allocate fees and expenses to benefit certain favored clients at the
expense of others, indirectly benefiting the adviser. Through our
examinations, our staff also has encountered instances where advisers
seek to limit their fiduciary duty or otherwise provide that the
adviser and its related persons will not be liable to the private fund
or investors for breaching its duties (including fiduciary duties) or
liabilities (that exist at law or in equity).\16\ We believe an adviser
that seeks to limit its liability in such a manner harms the private
fund (and, by extension, the private fund investors) by putting the
adviser's interests ahead of the interests of its private fund client.
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\15\ See, e.g., In the Matter of Lincolnshire Management, Inc.,
Investment Advisers Act Release No. 3927 (Sept. 27, 2014) (settled
action) (alleging private equity adviser to two private funds
misallocated expenses between the funds).
\16\ See, e.g., EXAMS National Examination Program Risk Alert:
Observations from Examinations of Private Fund Advisers (Jan. 27,
2022) (``EXAMS Private Funds Risk Alert 2022''), available at
https://www.sec.gov/files/private-fund-risk-alert-pt-2.pdf.
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Accordingly, based on our experience overseeing private fund
advisers, as well as private funds' impact on our financial
[[Page 16890]]
system, our economy, and American investors' savings, there is a need
to enhance the regulation of private fund advisers to protect
investors, promote more efficient capital markets, and encourage
capital formation. The Commission believes that many of the practices
it has observed are contrary to the public interest and protection of
investors and that these practices, if left unchecked, would continue
to harm investors.
In addition, given the lack of strong governance mechanisms at
private funds, their compliance programs take on added importance in
protecting investors.\17\ We are proposing an amendment to the Advisers
Act compliance rule to require all SEC-registered advisers, including
those that do not manage private funds, to document the annual review
of their compliance policies and procedures in writing.\18\ Based on
staff experience, some investment advisers do not make and preserve
written documentation of the annual review of their compliance policies
and procedures, which our examination staff relies on to help it
understand an adviser's compliance program, determine whether the
adviser is complying with the rule, and identify potential weaknesses
in the compliance program. Advisers can also rely on written
documentation of the annual review to promote an internal culture of
compliance and accountability. We believe that requiring written
documentation would focus renewed attention on the importance of the
annual compliance review process and would result in records of annual
compliance reviews that would allow our staff to assess whether an
adviser has complied with the review requirement of the compliance
rule.
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\17\ Id.
\18\ Proposed rule 206(4)-7(b).
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II. Discussion of Proposed Rules for Private Fund Advisers
We are proposing a series of rules under the Advisers Act that
would specifically address these practices by advisers to private
funds. The goal of this package of proposed reforms is to protect those
who directly or indirectly invest in private funds by increasing
visibility into certain practices, establishing requirements to address
certain practices that have the potential to lead to investor harm, and
prohibiting adviser activity that we believe is contrary to the public
interest and the protection of investors. While some of the investor
protection concerns identified herein may relate to an adviser's
activities with regard to other client types (e.g., separately managed
accounts, pooled vehicles that are not private funds as defined in the
Advisers Act), the proposed reforms are designed to address concerns
that arise out of the opacity that is prevalent in the private fund
structure. We also are proposing corresponding amendments to the books
and records requirements in rule 204-2.
We request comment on the following aspects of the package of
proposed reforms:
Are there certain activities that this package of proposed
reforms would address in the private fund context that we should also
address in other contexts (e.g., separately managed accounts)? Why or
why not?
Are there certain activities in the private fund context
that this package of proposed reforms is not addressing but that we
should address?
A. Quarterly Statements
The proposed rule would require an investment adviser that is
registered or required to be registered with the Commission to prepare
a quarterly statement that includes certain information regarding fees,
expenses, and performance for any private fund that it advises and
distribute the quarterly statement to the private fund's investors
within 45 days after each calendar quarter end, unless a quarterly
statement that complies with the proposed rule is prepared and
distributed by another person.\19\ We believe that periodic statements
detailing such information are necessary to improve the quality of
information provided to fund investors, allowing them to assess and
compare their private fund investments better. This information also
would improve their ability to monitor the private fund adviser to
ensure compliance with the private fund's governing agreements and
disclosures. While private fund advisers may currently provide
statements to investors, there is no requirement for advisers to do so
under the Advisers Act regulatory regime.
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\19\ Proposed rule 211(h)(1)-2.
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We believe advisers should provide statements to help an investor
better understand the relationship between the fees and expenses the
investor bears and the performance the investor receives from the
investment because of the opaque nature of the fees and expenses
typically associated with private fund investments. For example, a
private fund's governing documents (e.g., limited partnership
agreement, limited liability company agreement, or offering document)
may include broad characterizations of the types of potential fees and
expenses. In other cases, the fund's governing documents may give the
adviser significant discretion to determine which fees and expenses
relate to, and should be borne by, the fund. Examples of broad fee and
expense characterizations include ``any and all fees and expenses
related to the fund's business or activities,'' ``any and all fees and
expenses incurred in connection with the operation of the fund,'' and
``any and all fees and expenses that the adviser shall determine to be
related to the establishment and operation of the fund.'' These
provisions do not provide investors sufficiently detailed information
regarding what fees and expenses will be charged, how much those fees
and expenses will be, and how often fees and expenses will be charged.
We believe that periodic statements containing certain required
information would allow investors to understand and monitor their
private fund investments better. For example, investors could check
fees and expenses paid directly or indirectly by the private fund
against the private fund's governing documents. This information may
allow an investor to identify when the private fund is incorrectly, or
improperly, assessed a fee or expense by the adviser contrary to the
adviser's fiduciary duty or the fund's governing agreements or
disclosures. As discussed in more detail below, the proposed quarterly
statement also would improve transparency for investors into both the
myriad ways an adviser and its related persons benefit from their
relationship with the private fund and the scope of potential conflicts
of interests.
In addition, the proposed quarterly statement would allow a private
fund investor to compare cost and performance information across its
private fund investments. This information would help inform investment
decisions, including whether to remain invested in certain private
funds or to invest in other private funds managed by the adviser or its
related persons. More broadly, this disclosure would help inform
investors about the cost and performance dynamics of this marketplace
and potentially improve efficiency for future investments. For example,
if an investor owns interests in funds with similar investment
strategies, the investor may be in a better position to negotiate lower
fee rates for future investments because the investor would be aware of
the rates charged by certain advisers in that segment of the market.
We recognize that many private fund advisers contractually agree to
provide
[[Page 16891]]
fee, expense, and performance reporting to investors. For example,
advisers may provide investors with financial statements, schedules, or
other reports regarding the fund and its activities. However, not all
private fund investors are able to obtain this information. Others may
be able to obtain information, but it may not be sufficiently clear or
detailed reporting regarding the costs and performance of a particular
private fund. For example, some advisers report only aggregated
expenses, or do not provide detailed information about the calculation
and implementation of any negotiated rebates, credits, or offsets.
Without clear, detailed disclosure, investors are unable to measure and
assess the impact fees and expenses have on their investment returns.
Reporting practices also vary across the private funds industry due
to, among other things, different forms and templates. Because the
proposed requirement of quarterly statements would involve a degree of
standardization across the industry, we believe that investors would be
able to find and compare key information regarding fees, expenses, and
performance for funds with similar characteristics more easily than is
the case today. This has the potential to, in our view, bring greater
efficiencies to the marketplace by improving investor decision making.
For example, investors likely would be able to compare adviser
compensation across similar funds, which may assist investors in
determining whether to negotiate or renegotiate economic terms or
whether to invest or continue to invest in private funds managed by the
adviser.
The proposed quarterly statement requirement would provide fund-
wide reporting. We believe this approach would help private fund
investors compare the costs of investing across private funds. We are
not proposing to require private fund advisers to provide personalized
account statements showing each individual investor's fees, expenses,
and performance. The proposed quarterly statements are designed, in
part, to allow individual private fund investors to use fund-level
information to perform more personal, customized calculations. In
addition, these proposed requirements do not prevent an adviser from
providing (or causing a third party, such as an administrator,
consultant, or other service provider, to provide), or an investor from
negotiating, personalized reporting. In the registered fund context,
fund-level reporting has, in our view, enabled retail investors to
understand their investments better. We believe a comparable approach,
but one that is more suitable to the needs of investors in private
funds, is appropriate here.
We request comment on the following aspects of the proposed rule:
Should we, as proposed, require advisers to private funds
to prepare a quarterly statement providing standardized disclosures
regarding the cost of investing in the private fund and the private
fund's performance and distribute the quarterly statement to the fund's
investors? Should we instead require advisers to provide investors with
personalized information that takes into account the investors'
individual ownership stake in the fund in addition to, or in lieu of, a
statement covering the private fund? If so, what information should be
included in the personalized disclosure? For example, should the
statement reflect specific fee arrangements, including any offsets or
waivers applicable only to the investors receiving the statement? Do
advisers currently provide personalized fee, expense, and performance
disclosures? If so, what other types of information do advisers or
funds typically include? Do they automate such disclosures? How
expensive and complex would it be for advisers to create and deliver
personalized disclosures? How useful would it be for investors to
receive personalized disclosures?
Would investors find data regarding the private fund's
fees, expenses, and performance useful given that certain investors may
have different economic arrangements with the adviser, such as fee
breaks or expense caps? Should we require advisers to disclose in the
quarterly statement whether investors are subject to different economic
arrangements, whether documented in side letters or other written
agreements or, to the extent applicable, as a result of different class
terms? If so, should we require advisers to list the rates or otherwise
show a range?
Should the quarterly statement rule apply to registered
advisers to private funds as proposed or should it apply to all
advisers to private funds? Should it apply to exempt reporting
advisers? Should the rule include any exceptions for categories of
advisers? If so, what conditions should apply to such an exception?
Should the rule require advisers to prepare and distribute
the quarterly statements only to private fund investors, as proposed?
Alternatively, should the rule require advisers to provide quarterly
statements to investors in other types of pooled investment vehicles,
such as a vehicle that relies on an exclusion from the definition of
``investment company'' in section 3 of the Investment Company Act other
than section 3(c)(1) or 3(c)(7) of that Act? For example, should we
require advisers to provide quarterly statements to investors in pooled
investment vehicles that rely on the exclusion from the definition of
``investment company'' in section 3(c)(5)(C) of that Act? \20\
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\20\ Section 3(c)(5)(C) of the Investment Company Act provides
an exclusion from the definition of investment company for any
person who is not engaged in the business of issuing redeemable
securities, face-amount certificates of the installment type or
periodic payment plan certificates, and who is primarily engaged in
the business of purchasing or otherwise acquiring mortgages and
other liens on and interests in real estate.
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The proposed rule would require an adviser to distribute
the quarterly statement to the private fund's investors within 45 days
after each calendar quarter end, unless such a quarterly statement is
prepared and distributed by another person. Would this provision
eliminate burdens where there are multiple advisers to the same fund,
while still providing the fund's investors with the benefits of the
quarterly statement? Would the fund's primary adviser typically prepare
and distribute the quarterly statement in these circumstances? How
would advisers that do not prepare and distribute a quarterly statement
in reliance on another adviser demonstrate compliance with this
requirement?
The proposed rule would require advisers to prepare and
distribute a quarterly statement disclosing certain information
regarding a private fund's fees, expenses, and performance. Are there
alternative approaches we should require to improve investor protection
and bring greater efficiencies to the market? For example, should we
establish maximum fees that advisers may charge at the fund level?
Should we prohibit certain compensation arrangements, such as the ``2
and 20'' model? Should we prohibit advisers from receiving compensation
from portfolio investments to the extent they also receive management
fees from the fund? Should we require advisers to disclose their
anticipated management fee revenue and operating budget to private fund
investors or an LPAC or other similar body (despite the limitations of
private fund governance mechanisms, as discussed above) on an annual or
more frequent basis? Should we impose limitations on management fees
(which are typically paid regardless of whether the fund generates a
profit), but not impose limitations on performance-based compensation
(which is typically tied to the success of the fund)? Should we
prohibit
[[Page 16892]]
management fees from being charged as a percentage of committed capital
and instead only permit management fees to be based on invested
capital, net asset value, and other similar types of fee bases? Should
we prohibit certain expense practices or arrangements, such as expense
caps provided to certain, but not all, investors?
Similarly, should we prohibit certain types of private
fund performance information in the quarterly statement? For example,
should we prohibit advisers from presenting performance with the impact
of fund-level subscription facilities? Should we prohibit advisers from
presenting combined performance for multiple funds, such as a main fund
and a co-investment fund that pays lower or no fees?
Do private fund advisers or their related persons receive
other economic benefits that the rule should require advisers to
disclose in the quarterly statement? For example, should the quarterly
statement also require disclosure and quantification of the kinds of
economic benefits commonly received by advisers or their related
persons from broker-dealers or other service providers to private
funds, such as hedge funds? Why or why not?
1. Fee and Expense Disclosure
The proposed rule would require an investment adviser that is
registered or required to be registered to prepare and distribute
quarterly statements with certain information regarding fees and
expenses, including fees and expenses paid by underlying portfolio
investments to the adviser or its related persons. While the types of
fees and expenses charged to private funds can vary across the
industry, private funds are often more expensive than other asset
classes because the scope and magnitude of fees and expenses paid
directly and indirectly by private fund investors can be extensive.
Investors typically compensate the adviser for managing the affairs of
the fund, often in the form of management fees.\21\ On top of that,
investors typically pay or otherwise bear performance-based
compensation.\22\ A fund's portfolio investments also may pay fees to
the adviser or its related persons. For example, principals of the
adviser may receive cash or non-cash compensation--such as equity
awards or stock options--for serving as directors of a portfolio
investment owned by the private fund. Portfolio investment compensation
is typically in addition to compensation paid or allocated to the
adviser or its related persons at the fund level, unless the fund's
governing documents require the adviser to offset portfolio investment
compensation against other revenue streams or otherwise provide a
rebate to investors. Compensation at the ``portfolio investment-level''
is more common for certain private funds--such as private equity funds
or real estate funds--and less common for others--such as hedge funds.
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\21\ Certain private fund advisers utilize a pass-through
expense model where the private fund pays for most, if not all,
expenses, including the adviser's expenses, but the adviser does not
charge a management fee. See infra section II.D.2. for a discussion
of such pass-through expense models.
\22\ Investors typically enter into agreements under which the
private fund pays such compensation directly to the adviser or its
affiliates. Investors generally bear such compensation indirectly
through their investment in the private fund; however, certain
agreements may require investors to pay the adviser directly.
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Investors generally are required to bear all expenses related to
the operation of the fund and its portfolio investments. In addition to
expenses such as organizational and offering expenses, private fund
investors also frequently bear expenses that vary based on the private
fund's strategy and contractual agreements. For example, hedge fund
investors indirectly bear trading expenses. Investors in private equity
and venture capital funds indirectly bear expenses associated with fund
investments, such as deal sourcing and due diligence expenses,
including for investments that are unconsummated. Investors in private
funds with a real estate investment strategy also indirectly bear
expenses related to property management, environmental reviews, and
site inspections. These expenses generally are uncapped, and, unlike a
fund's performance-based compensation, private fund investors are
typically required to bear them regardless of whether the fund or the
applicable investment generates a positive return for investors.
Investors often lack transparency regarding the total cost of such
fees and expenses.\23\ For example, even though investors indirectly
bear the costs associated with a portfolio investment paying fees to
the adviser or its related persons, advisers often do not disclose the
magnitude or scope of these fees to investors. Opaque reporting
practices make it difficult for investors to measure and evaluate
performance accurately and to make informed investment decisions.\24\
Moreover, such reporting practices may prevent private fund investors
from assessing whether the type and amount of fees and expenses borne
by the private fund comply with the fund's governing agreements and can
lead to problematic compensation schemes and sales practices with
investors bearing excess or improper fees and expenses. The Commission
has brought enforcement actions related to the disclosure and
allocation of fees and expenses by private fund advisers. For example,
we have alleged in settled enforcement actions that advisers have
received undisclosed fees,\25\ improperly shifted expenses away from
the adviser,\26\ and misallocated fees and expenses among private fund
clients.\27\ Staff has observed similarly problematic compensation
schemes and sales practices in its examinations of private fund
advisers.\28\ For example, staff has observed advisers that charge
private funds for expenses not permitted under the fund documents.
Staff has also observed advisers improperly allocate shared expenses,
such as broken-deal, due diligence, and consultant expenses, among
private fund clients and their own accounts.
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\23\ See Hedge Fund Transparency: Cutting Through the Black Box,
The Hedge Fund Journal, James R. Hedges IV (Oct. 2006) (stating that
``the biggest challenges facing today's hedge fund industry may well
be the issues of transparency and disclosure''), available at
https://thehedgefundjournal.com/hedge-fund-transparency/; Fees &
Expenses, Private Funds CFO (Nov. 2020) at 12 (noting that it is
becoming increasingly complicated for investors to determine what
the management fee covers versus what is a partnership expense and
stating that the ``formulas for management fees are complex and
unique to different investors.''), available at https://www.troutman.com/images/content/2/6/269858/PFCFO-FeesExpenses-Nov20-Final.pdf.
\24\ See, e.g., Letter from State Treasurers and Comptrollers to
Mary Jo White, U.S. Securities & Exchange Commission (July 21,
2015), available at https://comptroller.nyc.gov/wp-content/uploads/documents/SEC_SignOnPDF.pdf; see also Letter from Americans for
Financial Reform Education Fund to Chairman Gary Gensler, U.S.
Securities & Exch. Commission (July 6, 2021), available at https://ourfinancialsecurity.org/wp-content/uploads/2021/07/Letter-to-SEC-re_-Private-Equity-7.6.21.pdf .
\25\ See, e.g., In the Matter of Blackstone Management Partners,
L.L.C., et. al., Investment Advisers Act Release No. 4219 (Oct. 7,
2015) (settled action).
\26\ See, e.g., In the Matter of Cherokee Investment Partners,
LLC and Cherokee Advisers, LLC, Investment Advisers Act Release No.
4258 (Nov. 5, 2015) (settled action).
\27\ See, e.g., In the Matter of Lincolnshire Management, Inc.,
Investment Advisers Act Release No. 3927 (Sept. 22, 2014) (settled
action).
\28\ See EXAMS Private Funds Risk Alert 2020, supra footnote 9.
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We have seen a significant increase in investors seeking
transparency regarding fees and expenses. For example, certain
investors and industry groups have encouraged advisers to adopt uniform
reporting templates to promote transparency and alignment of interests
between advisers and
[[Page 16893]]
investors.\29\ Despite these efforts, many advisers still do not
voluntarily provide adequate disclosure to investors. The proposed
quarterly statement rule would mandate them to provide it.
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\29\ See, e.g., Institutional Limited Partners Association
(``ILPA'') Reporting Template, available at https://ilpa.org/reporting-template/(stating that, since its release, more than one
hundred and forty organizations have endorsed the ILPA reporting
template, including more than twenty advisers).
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a. Private Fund-Level Disclosure
The proposed quarterly statement rule would require private fund
advisers to disclose the following information to investors in a table
format:
(1) A detailed accounting of all compensation, fees, and other
amounts allocated or paid to the adviser or any of its related persons
by the private fund during the reporting period (``adviser
compensation'');
(2) A detailed accounting of all fees and expenses paid by the
private fund during the reporting period other than those listed in
paragraph (1) above (``fund expenses''); and
(3) The amount of any offsets or rebates carried forward during the
reporting period to subsequent quarterly periods to reduce future
payments or allocations to the adviser or its related persons.\30\
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\30\ Proposed rule 211(h)(1)-2(b).
---------------------------------------------------------------------------
The table would provide investors with comprehensive fee and
expense disclosure for the prior quarterly period (or, in the case of a
newly formed private fund's initial quarterly statement, its first two
full calendar quarters of operating results).\31\ We will discuss each
of these elements in turn.
---------------------------------------------------------------------------
\31\ See proposed rule 211(h)(1)-1 (defining ``reporting
period'' as the private fund's calendar quarter covered by the
quarterly statement or, for the initial quarterly statement of a
newly formed private fund, the period covering the private fund's
first two full calendar quarters of operating results). To the
extent a newly formed private fund begins generating operating
results on a day other than the first day of a calendar quarter
(e.g., January 1), the adviser should include such partial quarter
and the immediately succeeding calendar quarters in the newly formed
private fund's initial quarterly statement. For example, if a fund
begins generating operating results on February 1, the reporting
period for the initial quarterly statement would cover the period
beginning on February 1 and ending on September 30.
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Adviser Compensation. The proposed rule would require the fund
table to show a detailed accounting of all adviser compensation during
the reporting period, with separate line items for each category of
allocation or payment reflecting the total dollar amount.\32\ The
proposed rule is designed to capture all compensation, fees, and other
amounts allocated or paid to the investment adviser or any of its
related persons by the fund, including, but not limited to, management,
advisory, sub-advisory, or similar fees or payments, and performance-
based compensation.\33\
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\32\ Proposed rule 211(h)(1)-2(b)(1).
\33\ We propose to define ``performance-based compensation'' as
allocations, payments, or distributions of capital based on the
private fund's (or its portfolio investments') capital gains and/or
capital appreciation. This definition's scope is broad and includes
cash or non-cash compensation, including, for example, in-kind
allocations, payments, or distributions of performance-based
compensation. We believe that the broad scope of the definition,
which would capture, without limitation, carried interest, incentive
fees, incentive allocations, or profit allocations, among other
forms of compensation, is appropriate given the various forms and
types of performance-based compensation across the private funds
industry.
---------------------------------------------------------------------------
We believe requiring advisers to disclose all forms of adviser
compensation as separate line items (without prescribing particular
categories of fees) is appropriate because it would encompass the
various forms of adviser compensation across the private funds
industry. Many private funds compensate advisers with a ``2 and 20''
arrangement, consisting of a 2% management fee and a 20% share of any
profits generated by the fund. Certain advisers, however, receive other
forms of compensation from private funds in addition to, or in lieu of,
such amounts. For example, certain advisers charge private funds
administration fees or servicing fees. The proposal would help ensure
disclosure of the various forms of adviser compensation, and the
corresponding dollar amounts of each type of compensation, to current
investors regardless of how an adviser characterizes the compensation
and regardless of the different economic arrangements in place. This
would allow investors to understand and assess the magnitude and scope
of adviser compensation better and help validate that adviser
compensation conforms to contractual agreements.
In addition to compensation paid to the adviser, the proposed rule
would require disclosure of compensation, fees, and other amounts
allocated or paid to the adviser's ``related persons.'' We propose to
define ``related persons'' to include: (i) All officers, partners, or
directors (or any person performing similar functions) of the adviser;
(ii) all persons directly or indirectly controlling or controlled by
the adviser; (iii) all current employees (other than employees
performing only clerical, administrative, support or similar functions)
of the adviser; and (iv) any person under common control with the
adviser.\34\ The term ``control'' would be defined to mean the power,
directly or indirectly, to direct the management or policies of a
person, whether through ownership of securities, by contract, or
otherwise.\35\
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\34\ Proposed rule 211(h)(1)-1. Form ADV also uses the same
definition. The regulations at 17 CFR 275.206(4)-2 (rule 206(4)-2)
use a similar definition by defining related person to include any
person, directly or indirectly, controlling or controlled by the
adviser, and any person that is under common control with the
adviser.
\35\ Proposed rule 211(h)(1)-1. The definition, in addition,
provides that (i) each of an investment adviser's officers,
partners, or directors exercising executive responsibility (or
persons having similar status or functions) is presumed to control
the investment adviser; (ii) a person is presumed to control a
corporation if the person: (A) Directly or indirectly has the right
to vote 25% or more of a class of the corporation's voting
securities; or (B) has the power to sell or direct the sale of 25%
or more of a class of the corporation's voting securities; (iii) a
person is presumed to control a partnership if the person has the
right to receive upon dissolution, or has contributed, 25% or more
of the capital of the partnership; (iv) a person is presumed to
control a limited liability company if the person: (A) Directly or
indirectly has the right to vote 25% or more of a class of the
interests of the limited liability company; (B) has the right to
receive upon dissolution, or has contributed, 25% or more of the
capital of the limited liability company; or (C) is an elected
manager of the limited liability company; or (v) a person is
presumed to control a trust if the person is a trustee or managing
agent of the trust. Form ADV also uses the same definition.
---------------------------------------------------------------------------
Many advisers conduct a single advisory business through multiple
separate legal entities or provide services to a private fund through
different affiliated entities. The proposed ``related person''
definition is designed to capture the various entities and personnel an
adviser may use to provide advisory services to, and receive
compensation from, private fund clients. We considered, but are not
proposing, a broader definition of related persons to include
additional entities related to the adviser or its personnel, such as
entities the adviser or its personnel own a financial interest in but
do not control. We are not proposing a broader definition because it
would likely capture entities or persons outside of the ones advisers
typically use to conduct a single advisory business. In addition, the
proposed definition is consistent with the definition of related person
used on Form ADV, which advisers have experience assessing as part of
their disclosure obligations on that form. We believe that the proposed
definition captures the relevant entities without being overly broad.
Fund Fees and Expenses. The proposed rule would also require the
fund table to show a detailed accounting of all fees and expenses paid
by the private fund during the reporting period, other than those
disclosed as adviser compensation, with separate line items for each
category of fee or
[[Page 16894]]
expense reflecting the total dollar amount.\36\ Similar to the approach
taken with respect to adviser compensation discussed above, the
proposed rule would capture all fund fees and expenses paid during the
reporting period including, but not limited to, organizational,
accounting, legal, administration, audit, tax, due diligence, and
travel expenses.
---------------------------------------------------------------------------
\36\ Proposed rule 211(h)(1)-2(b)(2).
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We have observed two general trends in the private funds industry
that support this approach. First, fund expenses have risen
significantly in recent years for certain private funds due to, among
other things, complex fund structures, global marketing and investment
efforts, and increased service provider costs.\37\ Advisers often pass
on such increases to the private funds they advise, without providing
investors with detailed disclosure about the magnitude or type of
expenses actually charged to the fund. Second, certain advisers have
shifted expenses related to their advisory business to private fund
clients.\38\ For example, some advisers charge private fund clients for
salaries and benefits related to personnel of the adviser. Such
expenses historically have been paid by advisers with management fee
proceeds or other revenue streams, but are increasingly being charged
as separate expenses that may not be transparent to fund investors.\39\
---------------------------------------------------------------------------
\37\ See, e.g., Coming to Terms: Private Equity Investors Face
Rising Costs, Extra Fees (Dec. 20, 2021), available at https://
www.wsj.com/articles/coming-to-terms-private-equity-investors-face-
rising-costs-extra-fees-
11640001604#:~:text=Coming%20to%20Terms%3A%20Private-
Equity%20Investors%20Face%20Rising%20Costs%2C,and%20some%20expenses%2
0are%20excluded%20from%20annual%20fees.; Key Findings ILPA Industry
Intelligence Report ``What is Market in Fund Terms?'' (2021) (``ILPA
Key Findings Report''), available at https://ilpa.org/wp-content/uploads/2021/10/Key-Findings-Industry-Intelligence-Report-Fund-Terms.pdf.
\38\ Such practice is often not disclosed, or not fully
disclosed, in private fund documents.
\39\ See ILPA Key Findings Report, supra footnote 37.
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The proposed quarterly statement rule would require a detailed
accounting of each category of fund expense. This would require
advisers to list each specific category of expense as a separate line
item, rather than permit advisers to group fund expenses into broad
categories. For example, if a fund paid insurance premiums,
administrator expenses, and audit fees during the reporting period, a
general reference to ``fund expenses'' on the quarterly statement would
not satisfy the detailed accounting requirement. Instead, an adviser
would be required to list each specific category of expense (i.e.,
insurance premiums, administrator expenses, and audit fees), and the
corresponding dollar amount, separately. As with adviser compensation,
we believe this approach would provide private fund investors with
sufficient detail to validate that the fund expenses borne by the fund
conform to contractual agreements.
To the extent a fund expense also could be characterized as adviser
compensation under the proposed rule, the proposed rule would require
advisers to disclose such payment or allocation as adviser compensation
and not as a fund expense in the quarterly statement. For example,
certain private funds may engage the adviser or its related persons to
provide services to the fund, such as consulting, legal, or back-office
services. An adviser would disclose any compensation, fees, or other
amounts allocated or paid by the fund for such services as part of the
detailed accounting of adviser compensation. This approach would help
ensure that investors understand the entire amount of adviser
compensation allocated or paid to the adviser and its related persons
during the reporting period.
Offsets, Rebates, and Waivers. We are proposing to require advisers
to disclose adviser compensation and fund expenses in the fund table
both before and after the application of any offsets, rebates, or
waivers.\40\ Specifically, the proposed rule would require an adviser
to present the dollar amount of each category of adviser compensation
or fund expense before and after any such reduction for the reporting
period.
---------------------------------------------------------------------------
\40\ Proposed rule 211(h)(1)-2(b).
---------------------------------------------------------------------------
Advisers may offset, rebate, or waive adviser compensation or fund
expenses in a number of circumstances. For example, a private equity
adviser may enter into a management services agreement with a fund's
portfolio company, requiring the company to pay the adviser a fee for
those services. To the extent the fund's governing agreement requires
the adviser to share the fee with the fund investors through an offset
to the management fee, the management fee would typically be reduced,
on a dollar-for-dollar basis, by an amount equal to the fee.\41\ Under
the proposed rule, the adviser would be required to list the management
fee both before and after the application of the fee offset.\42\
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\41\ The offset shifts some or all of the economic benefit of
the fee from the adviser to the private fund investors.
\42\ Offsets, rebates, and waivers applicable to certain, but
not all, investors through one or more separate arrangements would
be required to be reflected and described prominently in the fund-
wide numbers presented in the quarterly statement. See proposed rule
211(h)(1)-2(d) and (g).
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We considered whether to require advisers to disclose adviser
compensation and fund expenses only after the application of offsets,
rebates, and waivers, rather than before and after. We recognize that
investors may find the reduced numbers more meaningful, given that they
generally reflect the actual amounts borne by the fund during the
reporting period. We believe, however, that presenting both figures
would provide investors with greater transparency into advisers' fee
and expense practices, particularly with respect to how offsets,
rebates, and waivers affect adviser compensation. Transparency into fee
and expense practices is important because it would assist investors in
monitoring their private fund investments and, for certain investors,
would ease their own efforts at complying with their reporting
obligations.\43\ We also believe that advisers would have this
information readily available and both sets of figures would be helpful
to investors in monitoring whether and how offsets, rebates, and
waivers are applied.
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\43\ For example, certain investors, such as U.S. state pension
plans, may be required to report complete information regarding fees
and expenses paid to the adviser and its related persons.
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In addition, we are proposing to require advisers to disclose the
amount of any offsets or rebates carried forward during the reporting
period to subsequent periods to reduce future adviser compensation.\44\
This information would allow investors to understand whether they are
or the fund is entitled to additional reductions in future periods.\45\
Further, we believe that this information would assist investors with
their liquidity management and cash flow models, as they would have
greater insight into the fund's projected cash flows and their
obligations to satisfy future capital calls for adviser compensation
with cash on hand.
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\44\ Proposed rule 211(h)(1)-2(b)(3).
\45\ To the extent advisers are required to offset fund-level
compensation (e.g., management fees) by portfolio investment
compensation (e.g., monitoring fees), they typically do not reduce
adviser compensation below zero, meaning that, in the event the
monitoring fee offset amount exceeds the management fee for the
applicable period, some fund documents provide for ``carryforwards''
of the unused amount. The carryforwards are used to offset the
management fee in subsequent periods.
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We request comment on all aspects of the proposed content of the
fund fee and expense table, including the following items:
Should we require advisers to disclose all compensation
and fund expenses as proposed? Do commenters
[[Page 16895]]
agree with the scope of the proposal? Why or why not?
Would the proposed content result in fund-level fee and
expense disclosure that is meaningful to investors? Are there other
items that advisers should be required to disclose in the fund table?
Are there any proposed items that we should eliminate? Would more or
less information about the fees and expenses charged to the fund be
helpful for investors? Are there any revisions to the descriptions of
fees that would make the proposed disclosure more useful to investors?
Instead of the proposed approach, should we prescribe a
template for the fund table? Would the increased comparability of a
template be useful to investors? Would a template be flexible enough to
accommodate changes in the types of fees and expenses as well as the
types of offsets, rebates, or waivers used by private fund advisers?
Would a template necessitate repeated updating as the industry evolves?
Should we include any additional definitions of terms or
phrases for the fund table? Should we omit any definitions we have
proposed for the fund table?
The proposed rule would require an adviser to include the
compensation paid to a related person sub-adviser in its quarterly
statement. For private funds that have sub-advisers that are not
related persons, should we require a single quarterly statement showing
all adviser compensation (at both the adviser and sub-adviser levels)?
In cases where a non-related person sub-adviser does not prepare a
quarterly account statement in reliance on the adviser's preparation
and distribution of the quarterly statement to the fund's investors,
how would advisers reflect the compensation paid to the sub-adviser and
its related persons? Do commenters agree that such compensation would
be captured as a fund expense? Should we require a separate table
covering these fees and expenses, as well as a separate table showing
portfolio investment compensation paid to the sub-adviser or its
related person? How would advisers operationalize this requirement in
these circumstances?
Should we adopt the proposed definitions of ``related
persons'' and ``control'' as proposed? Are they too broad? Are the
proposed definitions broad enough? Should we add former personnel of
the adviser or its related persons to the proposed definition? If so,
for how long after a departure from the adviser or its related persons
should such personnel fall into the definition? Should the definition
of related person include family members of adviser personnel or
persons who share the same household with adviser personnel? Should the
definition capture any person directly or indirectly controlled by the
adviser's officers, partners, or directors (including any consulting
firms controlled by such persons)? Should it capture operational
partners, senior advisors, or other similar consultants of the adviser,
the private fund, or its portfolio investments? Should we add any
entity more than five percent of the ownership of which is held,
directly or indirectly, by the adviser or its personnel? Should the
definition include any person that receives, directly or indirectly,
management fees or performance based compensation from, or in respect
of, the fund; or any person that has an interest in the investment
adviser or general partner (or similar control person) of the fund? If
we adopt a different definition of ``related person'' than what is
being proposed, should we use a different defined term (such as
``related party'') to avoid confusion given that the term ``related
person'' is defined in Form ADV?
For purposes of the definition of ``control,'' are the
control presumptions appropriate in this context? Should we eliminate
or modify any of the presumptions? For example, should we eliminate
aspects of the definition that may capture passive investors who do not
have the power to direct the management or policies of the relevant
entity? Why or why not? Should we add any additional control
presumptions? For example, should an entity be presumed to be
controlled by an adviser to the extent the adviser has authority over
the entity's budget or whether to hire personnel or terminate their
employment?
The proposed rule includes a non-exhaustive list of
certain types of adviser compensation and fund expenses.\46\ Would this
information assist advisers in complying with the rule? Should we add
any additional types? If so, which ones and why?
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\46\ Proposed rule 211(h)(1)-2(b)(1) includes the following non-
exhaustive list of adviser compensation: Management, advisory, sub-
advisory, or similar fees or payments, and performance-based
compensation. Proposed rule 211(h)(1)-2(b)(2) includes the following
non-exhaustive list of fund expenses: Organizational, accounting,
legal, administration, audit, tax, due diligence, and travel fees
and expenses.
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Do private fund advisers or their related persons receive
other economic benefits that the rule should require advisers to
disclose in the quarterly statement? For example, should we require
hedge fund advisers to disclose the dollar amount of any soft dollar or
similar benefits provided by broker-dealers that execute trades for the
funds, or any benefits provided by hedge fund prime brokers?
Do commenters agree with the scope of the proposed
definition of ``performance-based compensation''? Should we specify the
types of compensation that should be included in the definition? For
example, should the definition specify that the term includes carried
interest, incentive fees, incentive allocations, performance fees, or
profit allocations?
Should we only require the table to disclose adviser
compensation and fund expenses after the application of any offsets,
rebates, or waivers, rather than before and after, as proposed? If so,
why?
Should we define offsets, rebates, and waivers? If so,
what definitions should we use and why? Are there any types of offsets,
rebates, and waivers that we should not require advisers to reflect in
the fund table? If so, which ones and why? To the extent that offsets,
rebates, or waivers are available to certain, but not all, investors,
are there any operational concerns with reflecting and describing those
offsets, rebates, or waivers in the fund-wide numbers presented in the
quarterly statement? Are there alternatives we should use?
Should we require advisers to disclose the amount of any
offsets or rebates carried forward during the reporting period to
subsequent periods to reduce future adviser compensation as proposed?
Would this information be helpful for investors? Do advisers already
provide this information in the fund's financial statements or
otherwise?
Should we require advisers to provide any additional
disclosures regarding fees and expenses in the quarterly statement? In
particular, should we require any disclosures from an investment
adviser's Form ADV Part 2A narrative brochure (if applicable) to be
included in the quarterly statement, such as more details about an
investment adviser's fees?
Should we tailor the disclosure requirements based on fund
type? For example, should the requirements or format for hedge funds
differ from the requirements and format for private equity funds? Are
there unique fees or expenses for types of funds that advisers should
be required to disclose or otherwise list as a separate line item? If
so, how should we define these types of funds for these purposes? For
example, should we use the definitions of such terms used on Form ADV?
[[Page 16896]]
Do any of the proposed requirements impose unnecessary
costs or compliance challenges? Please provide specific data. Are there
any modifications to the proposal that we could make that would lower
those costs or mitigate those challenges? Please provide examples.
The proposed quarterly statement prescribes minimum fee
and expense information that must be included. What are the benefits
and drawbacks of prescribing the minimum disclosure to be included in
the quarterly statement and otherwise permitting advisers to include
additional information? Do commenters agree that we should allow
advisers to include additional information? Would the inclusion of
additional information affect whether investors review the quarterly
statement?
Certain advisers use management fee waivers where the
amount of management fees paid by the fund to the adviser is reduced in
exchange for an increased interest in fund profits.\47\ Because fund
agreements often document such waivers with complex and highly
technical tax provisions, should we provide guidance to assist advisers
in complying with the proposed requirement to describe the manner in
which they are calculated or specify a methodology for such
calculations?
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\47\ Management fee waiver arrangements often provide certain
economic benefits for the adviser, such as the possibility of
reducing and/or deferring certain tax obligations.
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Should we permit advisers to exclude expenses from the
quarterly statement if they are below a certain threshold?
Alternatively, should we permit advisers to group expenses into broad
categories and disclose them under single line item--such as
``Miscellaneous Expenses'' or ``Other Expenses''--if the aggregate
amount is de minimis relative to the fund's size? Why or why not?
The proposed rule would require the initial quarterly
statement for newly formed funds to include start-up and organizational
fees of the fund if they were paid during the reporting period.
Instead, should the proposed rule exclude those fees and expenses?
Should the table provide fee and expense information for
any other periods? For example, should we require advisers to disclose
all adviser compensation and fund expenses since inception (in addition
to adviser compensation and fund expenses allocated or paid during the
applicable reporting period)? If so, should we require since-inception
information only for certain types of funds, such as closed-end private
funds, and not for other types of funds, such as open-end private
funds?
We recognize that certain private fund advisers may
already provide quarterly account or similar statements to investors,
such as advisers that rely on an exemption from certain disclosure and
recordkeeping requirements provided by U.S. Commodity Futures Trading
Commission regulations at 17 CFR 4.7. How often are private fund
advisers separately required to provide such quarterly statements, and
how often do they do so even when not required? Would there be any
overlap between the proposed quarterly statement and the existing
quarterly account or similar statements currently prepared by advisers?
b. Portfolio Investment-Level Disclosure
The proposed quarterly statement rule would require advisers to
disclose the following information with respect to any covered
portfolio investment,\48\ in a single table covering all such covered
portfolio investments:
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\48\ See proposed rule 211(h)(1)-1 (defining ``covered portfolio
investment'' as a portfolio investment that allocated or paid the
investment adviser or its related persons portfolio investment
compensation during the reporting period).
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(1) A detailed accounting of all portfolio investment compensation
allocated or paid by each covered portfolio investment during the
reporting period; \49\ and
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\49\ See proposed rule 211(h)(1)-1 (defining ``portfolio
investment compensation'' as any compensation, fees, and other
amounts allocated or paid to the investment adviser or any of its
related persons by the portfolio investment attributable to the
private fund's interest in such portfolio investment).
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(2) The private fund's ownership percentage of each such covered
portfolio investment as of the end of the reporting period or, if the
fund does not have an ownership interest in the covered portfolio
investment, the adviser would be required to list zero percent as the
fund's ownership percentage along with a brief description of the
fund's investment in such covered portfolio investment.\50\
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\50\ Proposed rule 211(h)(1)-2(c).
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The proposed rule defines ``portfolio investment'' as any entity or
issuer in which the private fund has invested directly or
indirectly.\51\ This definition is designed to capture any entity or
issuer in which the private fund holds an investment including through
holding companies, subsidiaries, acquisition vehicles, special purpose
vehicles, and other vehicles through which investments are made or
otherwise held by the private fund.\52\ As a result, the proposed
definition may capture more than one entity or issuer with respect to
any single investment made by a private fund. For example, if a private
fund invests directly in a holding company that owns two subsidiaries,
the proposed definition would capture all three entities. Depending on
a private fund's underlying investment structure, an adviser may have
to determine, in good faith, which entity or entities constitute the
portfolio investment under the proposed rule.
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\51\ Proposed rule 211(h)(1)-1.
\52\ Certain investment strategies can involve complex
transactions and the use of negotiated instruments or contracts,
such as derivatives, with counterparties. Although such trading
involves a risk that a counterparty will not settle a transaction or
otherwise fail to perform its obligations under the instrument or
contract and thus result in losses to the fund, we would generally
not consider the fund to have made an investment in the counterparty
in this context. We believe this approach is appropriate because any
gain or loss from the investment generally would be tied to the
performance of the derivative and the underlying reference security,
rather than the performance of the counterparty.
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We considered, but are not proposing, using the term ``portfolio
company,'' rather than ``portfolio investment.'' We believe that the
term ``portfolio company'' would be too narrow given that some private
funds do not invest in traditional operating companies. For example,
certain private funds originate loans and invest in credit-related
instruments, while others invest in more bespoke assets such as music
royalties, aircraft, and tanker vessels. The proposed rule would define
``portfolio investment'' to apply to all types of private fund
investments and structures. The proposed definition also is designed to
remain evergreen, capturing new investment structures as they continue
to evolve.
We recognize, however, that portfolio investments of certain
private funds may not pay or allocate portfolio-investment compensation
to an adviser or its related persons. For example, advisers to hedge
funds focusing on passive investments in public companies may be less
likely to receive portfolio-investment compensation than advisers to
private equity funds focusing on control-oriented investments in
private companies. Under the proposed rule, advisers would only be
required to disclose information regarding covered portfolio
investments, which we propose to define as portfolio investments that
allocated or paid the investment adviser or its related persons
portfolio investment compensation during the reporting period.\53\ We
[[Page 16897]]
believe this approach is appropriate because the portfolio investment
table is designed to highlight the scope and magnitude of any
investment-level compensation as well as to improve transparency for
investors into the potential conflicts of interest of the adviser and
its related persons. If an adviser does not receive such compensation,
we do not believe the adviser should have such a reporting obligation.
Accordingly, the proposed rule would not require advisers to list any
information regarding portfolio investments that do not fall within the
covered portfolio investment definition for the applicable reporting
period. These advisers, however, would need to identify portfolio
investment payments and allocations in order to know whether they must
provide the disclosures under this requirement.
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\53\ See proposed rule 211(h)(1)-1 (defining ``covered portfolio
investment'').
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Portfolio Investment Compensation. The proposed rule would require
the portfolio investment table to show a detailed accounting of all
portfolio investment compensation allocated or paid by each covered
portfolio investment during the reporting period, with separate line
items for each category of allocation of payment reflecting the total
dollar amount, including (though it is not limited to) origination,
management, consulting, monitoring, servicing, transaction,
administrative, advisory, closing, disposition, directors, trustees or
similar fees or payments by the covered portfolio investment to the
investment adviser or any of its related persons. An adviser should
disclose the identity of each covered portfolio investment to the
extent necessary for an investor to understand the nature of the
conflicts associated with such payments.
Similar to the approach taken with respect to adviser compensation
and fund expenses discussed above, the proposed rule would require a
detailed accounting of all portfolio investment compensation paid or
allocated to the adviser and its related persons.\54\ This would
require advisers to list each specific type of portfolio investment
compensation, and the corresponding dollar amount, as a separate line
item. We believe that this approach is appropriate given that portfolio
investment compensation can take many different forms and often varies
based on fund type. For example, portfolio investments of private
credit funds may pay the adviser a servicing fee for managing a pool of
loans held directly or indirectly by the fund. Portfolio investments of
private real estate funds may pay the adviser a property management fee
or a mortgage-servicing fee for managing the real estate investments
held directly or indirectly by the fund.
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\54\ Because advisers often use separate legal entities to
conduct a single advisory business, the proposed rule would capture
portfolio investment compensation paid to an adviser's related
persons.
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We believe that this disclosure would inform investors about the
scope of portfolio investment compensation paid to the adviser and
related persons, and could help provide insight into some of the
conflicts of interest some advisers face. For example, in cases where
the adviser controls the portfolio investment, the adviser also
generally has discretion over whether to charge portfolio investment
compensation and, if so, the rate, timing, method, amount, and
recipient of such compensation. Additionally, where the private fund's
governing documents require the adviser to offset portfolio investment
compensation against other revenue streams or otherwise provide a
rebate to investors, this information would also help investors monitor
the application of such offsets or rebates.
The proposed rule would require the adviser to disclose the amount
of portfolio investment compensation attributable to the private fund's
interest in the covered portfolio investment.\55\ Such amount would not
reflect the portion attributable to any other person's interest in the
covered portfolio investment. For example, if the private fund and
another person co-invested in the same portfolio investment and the
portfolio investment paid the private fund's adviser a monitoring fee,
the table would only list the total dollar amount of the monitoring fee
attributable to the fund's interest. We believe this approach is
appropriate because it would reflect the amount borne by the fund and,
by extension, the investors. This would be meaningful information for
investors because the amount attributable to the fund's interest
typically reduces the value of investors' indirect interest in the
portfolio investment.\56\ Subject to the requirements of the proposed
rule, advisers may, but are not required to, also list the portion of
the fee attributable to any other investor's interest in the portfolio
investment.
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\55\ See proposed rule 211(h)(1)-1 (defining ``portfolio
investment compensation'').
\56\ We believe that this information would be meaningful for
investors regardless of whether the private fund has an equity
ownership interest or another kind of interest in the covered
portfolio investment. For example, if a private fund's interest in a
covered portfolio investment is represented by a debt instrument,
the amount of portfolio-investment compensation paid or allocated to
the adviser may hinder or prevent the covered portfolio investment
from satisfying its obligations to the fund under the debt
instrument.
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Similar to the approach discussed above with respect to adviser
compensation and fund expenses, an adviser would be required to list
the amount of portfolio investment compensation allocated or paid with
respect to each covered portfolio investment both before and after the
application of any offsets, rebates, or waivers. This would require an
adviser to present the aggregate dollar amount attributable to the
fund's interest before and after any such reduction for the reporting
period. Advisers would be required to disclose the amount of any
portfolio investment compensation they initially charge and the amount
they ultimately retain at the expense of the private fund and its
investors. As with adviser compensation and fund expenses, we believe
this approach would provide investors with sufficient detail to
validate that portfolio investment compensation borne by the fund
conforms to contractual agreements.
Ownership Percentage. The proposed rule would require the portfolio
investment table to list the fund's ownership percentage of each
covered portfolio investment that paid or allocated portfolio-
investment compensation to the adviser or its related persons during
the reporting period.\57\ The adviser would be required to determine
the fund's ownership percentage as of the end of the reporting period.
We believe that this information would provide investors with helpful
context of the amount of portfolio investment compensation paid or
allocated to the adviser or its related persons relative to the fund's
ownership. For example, portfolio investment compensation may be
calculated based on the portfolio investment's total enterprise value
or other similar metric. We believe that the fund's ownership
percentage would help private fund investors understand and assess the
magnitude of such compensation, as well as how it affects the value of
the fund's investment.
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\57\ Proposed rule 211(h)(1)-2(c)(2). An adviser should also
list zero percent as the ownership percentage if the fund has sold
or completely written off its ownership interest in the covered
portfolio investment during the reporting period.
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We recognize that calculating the fund's ownership percentage may
be difficult in certain circumstances, especially for funds that do not
make equity investments in operating companies. For example, a private
equity secondaries fund may own a preferred security or a hybrid
instrument that entitles the fund to
[[Page 16898]]
priority distributions until it receives a certain return on its
initial investment. A direct lending fund may provide a loan to a
company that entitles the fund to receive interest payments and a
return of principal. If the fund does not have an ownership interest in
the covered portfolio investment, such as when the fund holds a debt
instrument, the adviser would be required to list zero percent as the
fund's ownership percentage, along with a brief description of the
fund's investment in the portfolio investment table, if the covered
portfolio investment paid or allocated portfolio-investment
compensation to adviser or its related persons during the reporting
period.
We request comment on all aspects of the proposed content of the
portfolio investment table, including the following items:
Would the proposed rule provide portfolio investment
compensation disclosure that is meaningful to investors? Should the
rule require advisers to disclose additional or different information
in the portfolio-investment table? Would more information about the
fees and expenses charged to portfolio investments be helpful for
investors?
Should we include any additional definitions of terms or
phrases for the portfolio-investment table? Should we omit any
definitions we have proposed for the portfolio-investment table?
Is the proposed definition of ``portfolio investment''
clear? Should we modify or revise the proposed definition? For example,
should we define ``portfolio investment'' as any person whose
securities are beneficially owned by the private fund or any person in
which the private fund owns an equity or debt interest? Alternatively,
should we define ``portfolio investment'' as any underlying company,
business, platform, issuer, or other person in which the private fund
has made, directly or indirectly, an investment? Should we permit
advisers to determine, in good faith, which entity or entities
constitute the portfolio investment for purposes of the quarterly
statement rule? For example, a fund of funds may indirectly invest in
hundreds of issuers or entities. Depending on the underlying structure,
control relationship, and reporting, the fund of funds' adviser may
have limited knowledge regarding such underlying entities or issuers.
Should we exclude such entities or issuers from the definition of
portfolio investment for such advisers? Is there a different standard
or test we should use? Should we require such adviser to conduct a
reasonable amount of diligence consistent with past practice and/or
industry standards? Why or why not?
As discussed above, to the extent a private fund enters
into a negotiated instrument, such as a derivative, with a
counterparty, we would not consider the private fund to have made an
investment in the counterparty. Do commenters agree with this approach?
Why or why not? Should we adopt a different approach for derivatives or
other similar instruments generally? For purposes of determining
whether the fund has made an investment in an issuer or entity, should
we only include equity investments? Should we exclude derivatives? Why
or why not? How should exchange-traded (i.e., not negotiated)
derivatives, including swaps and options, be treated for purposes of
the rule?
The proposed definition of portfolio investment would not
distinguish among different types of private funds. Is our approach in
this respect appropriate or should we treat certain funds differently
depending on their strategy or fund type? If so, how should we reflect
that treatment? For example, should we modify the definition with
respect to a real estate fund to reflect that such a fund generally
invests in real estate assets, rather than operating companies? Because
a secondaries fund may indirectly invest in a significant number of
underlying operating companies or other assets, should we limit the
``indirect'' component of the definition for such funds (or any other
funds that may have indirect exposure to a significant number of
companies or assets)? Why or why not? Would additional definitions be
appropriate or useful? Should the proposed rule define the term
``entity'' and/or ``issuer''? If so, how? Should the proposed rule
treat hedge funds, liquidity funds, and other open-end private funds
differently than private equity funds and other closed-end private
funds?
Should we adopt the approach with respect to portfolio-
investment compensation as proposed? Do commenters agree with the scope
of the proposal? Why or why not?
The proposed rule includes non-exhaustive lists of certain
types of fees. Would this information assist advisers in complying with
the rule? Should we add any additional types? If so, which ones and
why?
Should we require advisers to list each type of portfolio-
investment compensation as a separate line item as proposed? Would this
level of detail be helpful for investors with respect to portfolio-
investment reporting? Given that many funds require a management fee
offset of all portfolio-investment compensation, is this level of
detail necessary or useful to investors? Should we instead require
advisers to provide aggregate information for each covered portfolio
investment?
Should the rule permit advisers to use project or deal
names or other codes, and if so, what additional disclosures are
necessary for an investor to understand the nature of the conflicts?
We considered only requiring advisers to disclose the
amount of portfolio investment compensation after the application of
any offsets, rebates, or waivers, rather than before and after. We
believe the proposed approach would be more helpful for investors
because investors would have greater insight into the compensation
advisers initially charge and the amount they ultimately retain at the
expense of the private fund and its investors. Do commenters agree? Why
or why not?
Would information about a firm's services to portfolio
investments be helpful for investors? Are there any elements of the
proposed requirements that firms should or should not include? If so,
which ones and why?
We considered requiring advisers to disclose the total
portfolio-investment compensation for the reporting period as an
aggregate number, rather than providing the amount of compensation
allocated or paid by each covered portfolio investment as proposed.
However, we believe that investment-by-investment information would
provide investors with greater transparency into advisers' fee and
expense practices and thus be more helpful for investors. Do commenters
agree? Should we require advisers to report a consolidated ``top-line''
number that covers all covered portfolio investments?
Should we define the term ``ownership interest''? If so,
how should we define it? For purposes of the rule, should a private
fund be deemed to hold an ``ownership interest'' in a covered portfolio
investment only to the extent the fund has made an equity investment in
the covered portfolio investment? Why or why not? What types of funds
may not hold an ``ownership interest'' in a covered portfolio
investment?
The proposed rule would require advisers to list the
fund's ownership percentage of each covered portfolio investment.
Because the definition of ``portfolio investment'' could capture more
than one entity, will advisers be able to calculate the fund's
ownership percentage? Are there any changes to the proposed rule text
that could mitigate this challenge? If a portfolio investment captures
multiple entities,
[[Page 16899]]
should we require advisers to list the fund's overall ownership of such
entities? If so, what criteria should advisers use to determine a
fund's overall ownership?
Should we require advisers to disclose how they allocate
or apportion portfolio-investment compensation among multiple private
funds invested in the same covered portfolio investment? If so, how
should the portfolio investment table reflect this information?
Certain advisers have discretion or substantial influence
over whether to cause a fund's portfolio investment to compensate the
adviser or its related persons. Should the requirement to disclose
portfolio-investment compensation apply only to advisers that have such
discretion or authority? Should such requirement apply if the adviser
is entitled to appoint one or more directors to the portfolio
investment's board of directors or similar governing body (if
applicable)? Is there another standard we should require?
We recognize that certain private funds, such as
quantitative and algorithmic funds and other similar funds, may have
thousands of holdings and/or transactions during a quarter and that
those funds typically do not receive portfolio investment compensation.
While the proposed rule would not require an adviser to include any
portfolio investment that did not pay or allocate portfolio-investment
compensation to the adviser or its related persons during the reporting
period in its quarterly statement, these advisers would need to
consider how to identify such portfolio investment's payments and
allocations for purposes of complying with this disclosure requirement.
Should the rule provide any full or partial exceptions for such funds?
Should we require investment-level disclosure for quantitative,
algorithmic, and other similar funds only where they own above a
specified threshold percentage of the portfolio investment? For
example, should such funds only be required to provide investment-level
disclosure where they own 25% or more ownership of any class of voting
shares? Alternatively, should we use a lower ownership threshold, such
as 20%, 10%, or 5%? Should we adopt a similar approach for all private
funds, rather than just quantitative, algorithmic, and other similar
funds? If so, what threshold should we apply? For instance, should it
be 5%? Or 10%? A higher percentage?
Should we exclude certain types of private funds from
these disclosures? If so, which funds and how should we define them?
For example, should we exclude private funds that only hold (or
primarily hold) publicly traded securities, such as hedge funds?
Should we require layered disclosure for the portfolio-
investment table (i.e., short summaries of certain information with
references and links to other disclosures where interested investors
can find more information)? Would this approach encourage investors to
ask questions and seek more information about the adviser's practices?
Are there modifications or alternatives we should impose to improve the
utility of the information for private fund investors, such as
requiring the quarterly statement to present information in a tabular
format?
Are there particular funds that may require longer
quarterly statements than other funds? Please provide data regarding
the number of funds that have covered portfolio investments and, with
respect to those funds, the number of covered portfolio investments per
private fund. Should the Commission take into account the fact that
certain funds will have more covered portfolio investments than other
funds? For example, should we require funds that have more than a
specific number of covered portfolio investments, such as 50 or more
covered portfolio investments, to provide only portfolio-investment
level reporting for a subset of their covered portfolio investments,
such as a specific number of their largest holdings during the
reporting period (e.g., their largest ten, fifteen, or twenty
holdings)?
The proposed rule would require advisers to list zero
percent as the ownership percentage if the fund has completely sold or
completely written off its ownership interest in the covered portfolio
investment during the reporting period. Instead, should we require or
permit advisers to exclude any such portfolio investments from the
table? Why or why not?
The proposed rule would require the adviser to disclose
the amount of portfolio investment compensation attributable to the
private fund's interest in the covered portfolio investment that is
paid or allocated to the adviser and its related persons. Should we
require disclosure of portfolio compensation paid to other persons
(such as co-investors, joint venture partners, and other third parties)
to the extent such compensation reduces the value of the private fund's
interest in the portfolio investment?
c. Calculations and Cross References to Organizational and Offering
Documents
The proposed quarterly statement rule would require each statement
to include prominent disclosure regarding the manner in which expenses,
payments, allocations, rebates, waivers, and offsets are
calculated.\58\ This would generally have the effect of requiring
advisers to describe, for example, the structure of, and the method
used to determine, any performance-based compensation set forth in the
statement (such as the distribution waterfall, if applicable) and the
criteria on which each type of compensation is based (e.g., whether
compensation is fixed, based on performance over a certain period, or
based on the value of the fund's assets). We believe that this
disclosure would assist private fund investors in understanding and
evaluating the adviser's calculations.
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\58\ Proposed rule 211(h)(1)-2(d).
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To facilitate an investor's ability to seek additional information,
the quarterly statement also must include cross references to the
relevant sections of the private fund's organizational and offering
documents that set forth the calculation methodology.\59\ References to
these disclosures would be valuable so that the investor can compare
what the private fund's documents state the fund (and indirectly the
investors) will be obligated to pay to what the fund (and indirectly
the investors) actually paid during the reporting period and more
easily determine the accuracy of the charges. For example, including
this information on the quarterly statement would likely enable an
investor to confirm that the adviser calculated advisory fees in
accordance with the fund's organizational and offering documents and to
identify whether the adviser deducted or charged incorrect or
unauthorized amounts. We believe this information also would allow the
investor to assess the effect those fees and costs have had on its
investment.
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\59\ Id.
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We request comment on the following aspects of the proposed rule:
Should we allow flexibility in the words advisers use, as
proposed, or should we require advisers to include prescribed wording
in disclosing calculation methodology? If the latter, what prescribed
wording would be helpful for investors? Does the narrative style work
or are there other presentation formats that we should require?
Should we provide additional guidance or specify
additional requirements regarding what type of
[[Page 16900]]
disclosure generally should or must be included to describe the manner
in which expenses, payments, allocations, rebates, waivers, and offsets
are calculated? For example, should we provide sample disclosures
describing various calculations? Should the rule require advisers to
restate disclosures from offering memoranda (if applicable) regarding
the manner in which expenses, payments, allocations, rebates, waivers,
and offsets are calculated in the quarterly statement? Do commenters
believe that advisers would prefer to restate offering memoranda
disclosures rather than drafting new disclosures to avoid conflicting
interpretations of potentially complex fund terms? Should the rule only
require advisers to provide a cross reference to the language in the
fund's governing documents regarding this information (e.g.,
identifying the relevant document and page or section numbers)?
Would providing cross references, as proposed, to the
relevant sections of the private fund's organizational and offering
documents be helpful for investors? Would it permit investors to
``cross check'' or evaluate the adviser's calculations? Are there other
alternatives that would achieve our objectives?
2. Performance Disclosure
In addition to providing information regarding fees and expenses,
the proposed rule would require an adviser to include standardized fund
performance information in each quarterly statement provided to fund
investors. The proposed rule would require an adviser to a liquid fund
(as defined below) to show performance based on net total return on an
annual basis since the fund's inception, over prescribed time periods,
and on a quarterly basis for the current year. For illiquid funds (also
defined below), the proposed rule would require an adviser to show
performance based on the internal rate of return and a multiple of
invested capital. The proposed rule would require an adviser to display
the different categories of required performance information with equal
prominence.\60\
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\60\ Proposed rule 211(h)(1)-2(e)(2). For example, the proposed
rule would require an adviser to an illiquid fund to show gross
internal rate of return with the same prominence as net internal
rate of return. Similarly, the proposed rule would require an
adviser to a liquid fund to show the annual net total return for
each calendar year with the same prominence as the cumulative net
total return for the current calendar year as of the end of the most
recent calendar quarter covered by the quarterly statement.
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It is essential that quarterly statements include performance in
order to enable investors to compare private fund investments and
comprehensively understand their existing investments and determine
what to do holistically with their overall investment portfolio. A
quarterly statement that includes fee, expense, and performance
information would allow investors to monitor for abnormalities and
better understand the impact of fees and expenses on their investments.
For example, a quarterly statement that includes fee and expense, but
not performance, information would not allow an investor to perform a
cost-benefit analysis to determine whether to retain the current
investment or consider other options or, for an investor in an illiquid
fund, to determine whether to invest in other private funds managed by
the same adviser. In addition, current clients or investors may use
fee, expense, and performance information about their current
investments to inform their overall investment decisions (e.g., whether
to diversify) and their view of the market.
Although there are commonalities between the performance reporting
elements of the proposed rule and the performance elements of our
recently adopted marketing rule, the two rules satisfy somewhat
different policy goals. Our experience has led us to believe that,
while all clients and investors should be protected against misleading,
deceptive, and confusing information, as is the policy goal of the
marketing rule,\61\ the needs of current clients and investors often
differ in some respects from the needs of prospective clients and
investors, as detailed below. Current investors should receive
performance reporting that allows them to evaluate an investment
alongside corresponding fee and expense information. Current investors
also should receive performance reporting that is provided at timely,
predictable intervals so that an investor can monitor and evaluate its
investment progress over time, remain abreast of changes, compare
information from quarter to quarter, and take action where
possible.\62\
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\61\ See Investment Adviser Marketing, Investment Advisers Act
Release No. 5653 (Dec. 22, 2021) (``Marketing Release''), at section
II.A.2.a.iv (noting that the definition of ``advertisement''
includes a communication to a current investor that offers new or
additional advisory services with regard to securities, provided
that the communication otherwise satisfies the definition of
``advertisement.'').
\62\ The marketing rule and its specific protections would
generally not apply in the context of a quarterly statement. See
Marketing Release, supra footnote 61, at sections II.A.2.a.iv and
II.A.4. The compliance date for the Marketing Rule is November 4,
2022.
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Currently, there are various approaches to report private fund
performance to fund investors, often depending on the type of private
fund (e.g., the fund's strategy, structure, target asset class,
investment horizon, or liquidity profile). Certain of these approaches
may be misleading without the benefit of well-disclosed assumptions,
and others may lead to investor confusion. For example, an adviser
showing internal rate of return with the impact of fund-level
subscription facilities could mislead investors because that method of
calculation would artificially increase performance metrics.\63\ An
adviser showing private fund performance as compared to a public market
equivalent (``PME'') in a case where the private fund does not have an
appropriate benchmark could mislead investors to believe that the
private fund performance will meet or exceed the performance of the
PME. Certain investors may also mistakenly believe that their private
fund investment has a liquidity profile that is similar to an
investment in the PME or an index that is similar to the PME.
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\63\ See infra section II.A.2.b. (Performance Disclosure:
Illiquid Funds).
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Without standardized performance metrics (and adequate disclosure
of the criteria used and assumptions made in calculating the
performance),\64\ investors cannot compare their various private fund
investments managed by the same adviser nor can they gauge the value of
an adviser's investment management services by comparing the
performance of private funds advised by different advisers.\65\
Standardized performance information would help an investor decide
whether to continue to invest in the private fund, if redemption is
possible, as well as more holistically to make decisions about other
components of the investor's portfolio. Furthermore, we believe that
proposing to require advisers to show performance information alongside
fee and expense information as part of the quarterly statement would
paint a more complete picture of an investor's private fund investment.
This would particularly provide context for investors that are
[[Page 16901]]
paying performance-based compensation and would help investors
understand the true cost of investing in the private fund. This
proposed performance reporting would also provide greater transparency
into how private fund performance is calculated, improving an
investor's ability to interpret performance results.\66\
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\64\ Private funds can have various types of complicated
structures and involve complex financing mechanisms. As a result, an
adviser may need to make certain assumptions when calculating
performance for private funds, specifically illiquid funds.
\65\ See David Snow, Private Equity: A Brief Overview: An
introduction to the fundamentals of an expanding, global industry,
PEI Media (2007), at 11 (discussing variations on private equity
performance metrics).
\66\ Private fund investors increasingly request additional
disclosure regarding private fund performance, including
transparency into the calculation of the performance metrics. See,
e.g., GPs feel the strain as LPs push for more transparency on
portfolio performance and fee structures, Intertrust Group (July 6,
2020), available at https://www.intertrustgroup.com/news/gps-feel-the-strain-as-lps-push-for-more-transparency-on-portfolio-performance-and-fee-structures/; ILPA Principals 3.0, at 36
``Financial and Performance Reporting'' and ``Fund Marketing
Materials,'' available at https://ilpa.org/wp-content/flash/ILPA%20Principles%203.0/?page=36.
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The proposed rule recognizes the need for different performance
metrics for private funds based on certain fund characteristics, but
also imposes a general framework to ensure there is sufficient
standardization in order to provide useful, comparable information to
investors. An adviser would remain free to include other performance
metrics in the quarterly statement as long as the quarterly statement
presents the performance metrics prescribed by the proposed rule and
complies with the other requirements in the proposed rule. However,
advisers that choose to include additional information should consider
what other rules and regulations might apply. For example, although we
would not consider information in the quarterly statement required by
the proposed rule to be an ``advertisement'' under the marketing rule,
an adviser that offers new or additional investment advisory services
with regard to securities in the quarterly statement would need to
consider whether such information would be subject to the marketing
rule.\67\ An adviser would also need to consider whether performance
information presented outside of the required quarterly statement, even
if it contains some of the same information as the quarterly statement,
would be subject to, and meet the requirements of, the marketing rule.
Regardless, the quarterly statement would be subject to the anti-fraud
provisions of the Federal securities laws.\68\
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\67\ See 17 CFR 275.206(4)-1 (rule 206(4)-1). A communication to
a current investor is an ``advertisement'' when it offers new or
additional investment advisory services with regard to securities.
\68\ This would include the anti-fraud provisions of section 206
of the Advisers Act, rule 206(4)-8 under the Advisers Act, section
17(a) of the Securities Act, and section 10(b) of the Exchange Act
(and 17 CFR 240.10b-5 (rule 10b-5 thereunder)), to the extent
relevant.
---------------------------------------------------------------------------
Liquid v. Illiquid Fund Determination
The proposed performance disclosure requirements of the quarterly
statement rule would require an adviser first to determine whether its
private fund client is an illiquid or liquid fund, as defined in the
proposed rule, no later than the time the adviser sends the initial
quarterly statement.\69\ The adviser would then be required to present
certain performance information depending on this categorization. The
purpose of these definitions is to distinguish which of the two
particular performance reporting methods would apply and is most
appropriate, resulting in a more accurate portrayal of the fund's
returns over time and allowing for more standardized comparisons of the
performance of similar funds.
---------------------------------------------------------------------------
\69\ Proposed rule 211(h)(1)-2(e)(1). The proposed rule does not
require the adviser to revisit the determination periodically;
however, advisers should generally consider whether they are
providing accurate information to investors and whether they need to
revisit the liquid/illiquid determination based on changes in the
fund.
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We propose to define an illiquid fund as a private fund that: (i)
Has a limited life; (ii) does not continuously raise capital; (iii) is
not required to redeem interests upon an investor's request; (iv) has
as a predominant operating strategy the return of the proceeds from
disposition of investments to investors; (v) has limited opportunities,
if any, for investors to withdraw before termination of the fund; and
(vi) does not routinely acquire (directly or indirectly) as part of its
investment strategy market-traded securities and derivative
instruments.\70\ We believe these factors are consistent with the
characteristics of illiquid funds and these factors would align with
the current factors for determining how certain types of private funds
should report performance under U.S. Generally Accepted Accounting
Principles (``U.S. GAAP'').\71\
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\70\ Proposed rule 211(h)(1)-1 (defining ``illiquid fund'').
\71\ See GAAP ASC 946-205-50-23/24.
---------------------------------------------------------------------------
Private funds that fall into the proposed ``illiquid fund''
definition are generally closed-end funds that do not offer periodic
redemption options, other than in exceptional circumstances, such as in
response to regulatory events. They also do not invest in publicly
traded securities, except for investing a de minimis amount of liquid
assets. We believe that many private equity, real estate, and venture
capital funds would fall into the illiquid fund definition, and
therefore, the proposed rule would require advisers to these types of
funds to provide performance metrics that recognize their unique
characteristics, such as irregular cash flows, which otherwise make
measuring performance difficult for both advisers and investors as
discussed below.
We propose to define a ``liquid fund'' as any private fund that is
not an illiquid fund.\72\ Private funds that fall into the ``liquid
fund'' definition generally allow periodic investor redemptions, such
as monthly, quarterly, or semi-annually. They also primarily invest in
market-traded securities, except for a de minimis amount of illiquid
assets, and therefore determine their net asset value on a regular
basis. Most hedge funds would likely fall into the liquid fund
definition, and therefore, the proposed rule would require advisers to
these types of funds to provide performance metrics that show the year-
over-year return using the market value of the underlying assets. We
acknowledge, however, that there could be circumstances where an
adviser would determine a hedge fund is an illiquid fund because it
holds less liquid investments or has limited investors' ability to
redeem some or all of their interests in the fund. We also recognize
that some private funds may not neatly fit into the liquid or illiquid
designations. For example, a hybrid fund is a type of private fund that
can have characteristics of both liquid and illiquid funds, and whether
the fund is treated as a liquid or illiquid fund under the rule would
depend on the facts and circumstances.
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\72\ Proposed rule 211(h)(1)-1 (defining ``liquid fund'').
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In any case, the proposed rule would require advisers to provide
performance reporting for each private fund as part of the fund's
quarterly statement. The determination of whether a fund is liquid or
illiquid dictates the type of performance reporting that must be
included and, because it would result in funds with similar
characteristics presenting the same type of performance metrics, we
believe this approach would improve comparability of private fund
performance reporting for fund investors. As indicated below, we
welcome comment on whether these definitions lead to meaningful
performance reporting for different types of private funds in light of
the myriad fund strategies and structures.
We request comment on the following aspects of the proposed
performance disclosure requirement:
Should the proposed rule require advisers to include
performance
[[Page 16902]]
information in investor quarterly statements? Why or why not?
Should the proposed rule require advisers to determine
whether a private fund is a liquid or illiquid fund and provide
performance metrics based on that determination? Alternatively, should
the rule eliminate the definitions and give advisers discretion to
provide the proposed performance metrics that they believe most
accurately portray the fund's returns?
Should we define ``illiquid fund'' and ``liquid fund'' as
proposed or are there alternative definitions we should use? Are there
other terms we should use for these purposes? For example, should we
refer to the types of funds that would provide annual net total returns
under the rule as ``annual return funds'' and those that would provide
internal rates of return (IRR) and a multiple of invested cash (MOIC)
under the rule as ``IRR/MOIC funds''?
Are the six factors used in the definition of ``illiquid
fund'' sufficient to capture most funds for which an annual net total
return is not an appropriate measure of performance? Are there any
factors we should add? For example, should we add a factor regarding
whether the fund produces irregular cash flows or whether the fund
takes into account unrealized gains when calculating performance-based
compensation? Should we add as a factor whether the private fund pays
carried interest? Are there factors we should eliminate?
Should we define additional terms or phrases used within
the definition of ``illiquid fund,'' such as ``has as a predominant
operating strategy the return of the proceeds from disposition of
investments to investors''? Would this characteristic carve out certain
funds, such as real estate funds and credit funds, for which we
generally believe internal rates of return and a multiple of invested
capital are the appropriate performance measures? If so, why? Should we
eliminate or modify this characteristic in the definition of ``illiquid
fund''?
Should the proposed rule define a ``liquid fund'' based on
certain characteristics? If so, what characteristics? For example,
should we define it as a private fund that requires investors to
contribute all, or substantially all, of their capital at the time of
investment, and invests no more than a de minimis amount of assets in
illiquid investments? If so, how should we define ``illiquid
investments''? Are there other characteristics relating to redemptions,
cash flows, or tax treatment that we should use to define the types of
funds that should provide annual net total return metrics?
Will advisers be able to determine whether a private fund
it manages is a liquid or illiquid fund? For example, how would an
adviser classify certain types of hybrid funds under the proposed rule?
Should the rule include a third category of funds for hybrid or other
funds? If so, what definition should we use? Should we amend the
proposed definitions if we adopt a third category of funds (e.g.,
should we revise the definition of ``liquid fund'' given that the
proposal defines ``liquid fund'' as any private fund that is not an
illiquid fund)? If a fund falls within the third category, should the
rule require or permit the private fund to provide performance metrics
that most accurately portray the fund's returns?
Are there scenarios in which an adviser might initially
classify a fund as illiquid, but the fund later transitions to a liquid
fund (or vice versa)? Should we provide additional flexibility in these
circumstances? Should the proposed rule require advisers to revisit
periodically their determination of a fund's liquidity status? For
example, should the proposed rule require advisers to revisit the
liquid/illiquid determination annually, semi-annually, or quarterly?
How would an adviser to a private fund with an illiquid
side pocket classify the private fund under the proposed rule's
definitions for liquid and illiquid funds? For example, would the
adviser treat the entire private fund as illiquid because of the side
pocket? Why or why not? Should we permit or require the adviser to
classify the side pocket as an illiquid fund, with the remaining
portion of the private fund classified as a liquid fund?
Instead of requiring advisers to show performance with
equal prominence, should the proposed rule instead allow advisers to
feature certain performance with greater prominence than other
performance as long as all of the information is included in the
quarterly statement? Why or why not?
a. Liquid Funds
The proposed rule would require advisers to liquid funds to
disclose performance information in quarterly statements for the
following periods. First, an adviser to a liquid fund would be required
to disclose the liquid fund's annual net total returns for each
calendar year since inception. For example, a liquid fund that
commenced operations four calendar years ago would show annual net
total returns for each of the first four years since its inception.\73\
We believe this information would provide fund investors with a
comprehensive overview of the fund's performance over the life of the
fund and improve an investor's ability to compare the fund's
performance with other similar funds. As noted above, investors can use
performance information in connection with fee and expense information
to analyze the value of their private fund investments. The proposed
requirement would prevent advisers from including only recent
performance results or presenting only results or periods with strong
performance. For similar reasons, it also would require an adviser to
present these various time periods with equal prominence.
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\73\ If a private fund's inception date were other than on the
first day of a calendar year, the private fund would show
performance for a stub period and then show calendar year
performance. For example, if the four-year period ended on October
31, 2021, and the fund's inception date was August 31, 2017, the
fund would show full calendar year performance for 2018, 2019, and
2020, and partial year performance in 2017.
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Second, the adviser would be required to show the liquid fund's
average annual net total returns over the one-, five-, and ten-calendar
year periods.\74\ However, if the private fund did not exist for one of
these prescribed time periods, then the adviser would not be required
to provide that information. Requiring performance over these time
periods would provide investors with standardized performance metrics
that would reflect how the private fund performed during different
market or economic conditions. These time periods would provide
reference points for private fund investors, particularly when
comparing two or more private fund investments, and would provide
private fund investors with aggregate performance information that can
serve as a helpful summary of the fund's performance.
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\74\ Proposed rule 211(h)(1)-2(e)(2)(i)(B).
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Third, the adviser would be required to show the liquid fund's
cumulative net total return for the current calendar year as of the end
of the most recent calendar quarter covered by the quarterly statement.
For example, a liquid fund that has been in operations for four
calendar years (beginning on January 1) and seven months would show the
cumulative net total return for the current calendar year through the
end of the second quarter. We believe this information would provide
fund investors with insight into the fund's most recent performance,
which investors could use to assess the fund's performance during
current market
[[Page 16903]]
conditions. This quarterly performance information also would provide
helpful context for reviewing and monitoring the fees and expenses
borne by the fund during the quarter, which the quarterly statement
would disclose.
We believe these performance metrics would allow investors to
assess these funds' performance because they ordinarily invest in
market-traded securities, which are primarily liquid. As a result,
liquid funds generally are able to determine their net asset value on a
regular basis and compute the year-over-year return using the market-
based value of the underlying assets. We have taken a similar approach
with regard to registered funds, which also invest a substantial amount
of their assets in primarily liquid underlying holdings (e.g., publicly
traded securities).\75\ As a result, liquid funds, like registered
funds, currently generally report performance on an annual and
quarterly basis. Investors in a private fund that is a liquid fund
would similarly find this information helpful. Most traditional hedge
funds would likely fall into the liquid bucket and would need to
provide disclosures regarding the underlying assumptions of the
performance (e.g., whether dividends or other distributions are
reinvested).\76\
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\75\ See Form N-1A. This form requires registered investment
companies to report to investors and file with the SEC documents
containing the fund's annual total returns by calendar year and the
highest and lowest returns for a calendar quarter, among other
performance information.
\76\ See infra section II.A.2.c (Prominent Disclosure of
Performance Calculation Information).
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We request comment on the following with respect to the proposed
liquid fund performance requirement:
Should we require advisers to provide annual net total
returns for liquid funds, as proposed? Would showing annual net total
returns for each calendar year since a private fund's inception be
overly burdensome for older funds? Would performance information that
is more than 10 years old be useful to investors? Why or why not?
Should the proposed rule define ``annual net total
return'' or specify the format in which advisers must present the
annual net total returns? Should the proposed rule specify how advisers
should calculate the annual net total return, similar to Form N-1A?
\77\
---------------------------------------------------------------------------
\77\ See Form N-1A, Item 26(b).
---------------------------------------------------------------------------
The proposed rule would require advisers to provide
performance information for each calendar year since inception and over
prescribed time periods (one-, five-, and ten-year periods). Should the
proposed rule instead only require an adviser to satisfy one of these
requirements (i.e., provide performance each calendar year since
inception or provide performance over the prescribed time periods)? For
funds that have not been in existence for one of the prescribed time
periods, should the proposed rule require the adviser to show the
average annual net total return since inception, instead of the
prescribed time period?
The proposed rule would require advisers to provide
average annual net total returns for the private fund over the one-,
five-, and ten-calendar year periods. However, the proposal would not
prohibit advisers from providing additional information. Should we
allow advisers to provide performance information for annual periods
other than calendar years?
Should the proposed rule define ``average annual net total
return'' or specify the format in which advisers must present the
average annual net total returns?
The proposed rule would require an adviser to provide
``the cumulative net total return for the current calendar year.''
Instead of using the word ``cumulative'' net total return, should the
rule use the phrase ``year to date'' net total return?
To the extent certain liquid funds quote yields rather
than returns, should such funds be required or permitted to quote
yields in addition to or instead of returns?
b. Illiquid Funds
The proposed rule would require advisers to illiquid funds to
disclose the following performance measures in the quarterly statement,
shown since inception of the illiquid fund and computed without the
impact of any fund-level subscription facilities:
(i) Gross internal rate of return and gross multiple of invested
capital for the illiquid fund;
(ii) Net internal rate of return and net multiple of invested
capital for the illiquid fund; and
(iii) Gross internal rate of return and gross multiple of invested
capital for the realized and unrealized portions of the illiquid fund's
portfolio, with the realized and unrealized performance shown
separately.
The proposed rule also would require advisers to provide investors
with a statement of contributions and distributions for the illiquid
fund.\78\
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\78\ Proposed rule 211(h)(1)-2(e)(2)(ii).
---------------------------------------------------------------------------
Since Inception. The proposed rule would require an adviser to
disclose the illiquid fund's performance measures since inception. This
proposed requirement would prevent advisers from including only recent
performance results or presenting only results or periods with strong
performance, which could mislead investors. We propose to require this
for all illiquid fund performance measures under the proposed rule,
including the measures for the realized and unrealized portions of the
illiquid fund's portfolio.
The proposed rule would require an adviser to include performance
measures for the illiquid fund through the end of the quarter covered
by the quarterly statement. We recognize, however, that certain funds
may need information from portfolio investments and other third parties
to generate performance data and thus may not have the necessary
information prior to the distribution of the quarterly statement.
Accordingly, to the extent quarter-end numbers are not available at the
time of distribution of the quarterly statement, an adviser would be
required to include performance measures through the most recent
practicable date, which we generally believe would be through the end
of the quarter immediately preceding the quarter covered by the
quarterly statement. The proposed rule would require the quarterly
statement to reference the date the performance information is current
through (e.g., December 31, 2021).\79\
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\79\ Proposed rule 211(h)(1)-2(e)(2)(iii).
---------------------------------------------------------------------------
Computed Without the Impact of Fund-Level Subscription Facilities.
The proposed rule would require advisers to calculate performance
measures for each illiquid fund as if the private fund called investor
capital, rather than drawing down on fund-level subscription
facilities.\80\ Such facilities enable the fund to use loan proceeds--
rather than investor capital--to initially fund investments and pay
expenses. This practice permits the fund to delay the calling of
capital from investors, which has the potential to increase performance
metrics artificially.
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\80\ As discussed below, the proposed rule would also require
advisers to prominently disclose the criteria used, and assumptions
made, in calculating performance. This would include the criteria
and assumptions used to prepare an illiquid fund's unlevered
performance measures.
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Many advisers currently provide performance figures that reflect
the impact of fund-level subscription facilities. These ``levered''
performance figures often do not reflect the fund's actual performance
and have the potential to mislead investors.\81\ For
[[Page 16904]]
example, an investor could reasonably believe that levered performance
results are similar to those that the investor has achieved from its
investment in the fund. We believe that unlevered performance figures
would provide investors with more meaningful data and improve the
comparability of returns.
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\81\ We recognize that fund-level subscription facilities can be
an important cash management tool for both advisers and investors.
For example, a fund may use a subscription facility to reduce the
overall number of capital calls and to enhance its ability to
execute deals quickly and efficiently.
---------------------------------------------------------------------------
We propose to define ``fund-level subscription facilities'' as any
subscription facilities, subscription line financing, capital call
facilities, capital commitment facilities, bridge lines, or other
indebtedness incurred by the private fund that is secured by the
unfunded capital commitments of the private fund's investors.\82\ This
definition is designed to capture the various types of subscription
facilities prevalent in the market that serve as temporary replacements
or substitutes for investor capital.\83\
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\82\ Proposed rule 211(h)(1)-1. The proposed rule defines
``unfunded capital commitments'' as committed capital that has not
yet been contributed to the private fund by investors, and
``committed capital'' as any commitment pursuant to which a person
is obligated to acquire an interest in, or make capital
contributions to, the private fund. See id.
\83\ We recognize that a private fund may guarantee portfolio
investment indebtedness. In such a situation, if the portfolio
investment does not have sufficient cash flow to pay its debt
obligations, the fund may be required to cover the shortfall to
satisfy its guarantee. Even though investors' unfunded commitments
may indirectly support the fund's guarantee, the proposed definition
would not cover such fund guarantees. Unlike fund-level subscription
facilities, such guarantees generally are not put in place to enable
the fund to delay the calling of investor capital.
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We would generally interpret the phrase computed without the impact
of fund-level subscription facilities to require advisers to exclude
fees and expenses associated with the subscription facility, such as
the interest expense, when calculating net performance figures and
preparing the statement of contributions and distributions. This
approach would cause the net returns for many funds to be higher than
would be the case if such amounts were included. We believe that this
approach is appropriate, however, because it is consistent with the
policy goal of this aspect of the proposed rule (i.e., requiring
advisers to show private fund investors the returns the fund would have
achieved if there were no subscription facility).\84\ We request
comment below on whether this approach is appropriate.
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\84\ The proposed rule nevertheless would require advisers to
reflect the fees and expenses associated with the subscription
facility in the quarterly statement's fee and expense table.
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Fund-Level Performance. The proposed rule would require an adviser
to disclose an illiquid fund's gross and net internal rate of return
and gross and net multiple of invested capital for the illiquid fund.
The proposed rule also would require an adviser to provide a statement
of contributions and distributions for the illiquid fund reflecting the
aggregate cash inflows from investors and the aggregate cash outflows
from the fund to investors, along with the fund's net asset value.
We recognize that illiquid funds have unique characteristics, such
as irregular cash flows, that make measuring performance difficult for
both advisers and investors. We also recognize that internal rate of
return and multiple of invested capital, each as discussed below, have
their drawbacks as performance metrics.\85\ We believe, however, that
these metrics, combined with a statement of contributions and
distributions reflecting cash flows, would help investors holistically
understand the fund's performance, allow investors to diligence the
fund's performance, and calculate other performance metrics they may
find helpful. When presented in accordance with the conditions and
other disclosures required under the proposed rule, such standardized
reporting measures would provide meaningful performance information for
investors, allowing them to compare returns among funds and also to
make more-informed decisions.
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\85\ For example, multiple of invested capital does not factor
in the amount of the time it takes for a fund to generate a return,
and internal rate of return assumes early distributions will be
reinvested at the same rate of return generated at the initial exit.
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We propose to define ``internal rate of return'' as the discount
rate that causes the net present value of all cash flows throughout the
life of the private fund to be equal to zero.\86\ Cash flows would be
represented by capital contributions (i.e., cash inflows) and fund
distributions (i.e., cash outflows), and the unrealized value of the
fund would be represented by a fund distribution (i.e., a cash
outflow). This definition would provide investors with a time-adjusted
return that takes into account the size and timing of a fund's cash
flows and its unrealized value at the time of calculation.\87\
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\86\ Proposed rule 211(h)(1)-1 (defining ``gross IRR'' and ``net
IRR'').
\87\ When calculating a fund's internal rate of return, an
adviser would need to take into account the specific date a cash
flow occurred (or is deemed to occur). Certain electronic
spreadsheet programs have ``XIRR'' or other similar formulas that
require the user to input the applicable dates. The proposed
requirement that an illiquid fund present its performance using an
internal rate of return aligns with the U.S. GAAP criteria used to
determine when a private fund must present performance using an
internal rate of return in its audited financial statements. See
U.S. GAAP ASC 946-205-50-23/24.
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We propose to define ``multiple of invested capital'' as (i) the
sum of: (A) The unrealized value of the illiquid fund; and (B) the
value of all distributions made by the illiquid fund; (ii) divided by
the total capital contributed to the illiquid fund by its
investors.\88\ This definition is intended to provide investors with a
measure of the fund's aggregate value (i.e., the sum of clauses (i)(A)
and (i)(B)) relative to the capital invested (i.e., clause (ii)) as of
the end of the applicable reporting period. Unlike the definition of
internal rate of return, the multiple of invested capital definition
would not take into account the amount of time it takes for a fund to
generate a return (meaning that the multiple of invested capital
measure would focus on ``how much'' rather than ``when'').
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\88\ Proposed rule 211(h)(1)-1 (defining ``gross MOIC'' and
``net MOIC'').
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We believe that the proposed definitions of internal rate of return
and multiple of invested capital are generally consistent with how the
industry currently calculates such performance metrics. For example,
most advisers use electronic spreadsheet programs to calculate a fund's
internal rate of return. Such programs typically calculate the internal
rate of return as the interest rate for an investment consisting of
payments (cash outflows) and income (cash inflows) received over a
period.\89\ However, we have observed certain advisers deviate from
standard formulas, or make various assumptions, when calculating a
private fund's performance. Accordingly, we believe that prescribing
definitions would decrease the risk of different advisers presenting
internal rate of return and multiple of invested capital performance
figures that are not comparable. Both definitions are designed to limit
any deviations in calculating the standardized performance prescribed
by the proposed rule. We believe that this approach is appropriate
because it would provide a degree of standardization and provide
investors with the relevant information to compare performance.
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\89\ See, e.g., IRR Function, available at https://support.microsoft.com/en-us/office/irr-function-64925eaa-9988-495b-b290-3ad0c163c1bc (noting that the internal rate of return is
closely related to net present value and that the rate of return
calculated by the internal rate of return is the interest rate
corresponding to a zero net present value).
---------------------------------------------------------------------------
An adviser would be required to present each performance metric on
a gross and net basis.\90\ Under the proposed rule, an illiquid fund's
gross
[[Page 16905]]
performance would not reflect the deduction of fees, expenses, and
performance-based compensation borne by the private fund.\91\ We
believe that presenting both gross and net performance measures for the
illiquid fund would prevent investors from being misled. We believe
that gross performance would provide insight into the profitability of
underlying investments selected by the adviser. Solely presenting gross
performance, however, may imply that investors have received the full
amount of such returns. The net performance would assist investors in
understanding the actual returns received and, when presented alongside
gross performance, the negative effect fees, expenses, and performance-
based compensation have had on past performance.
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\90\ Proposed rule 211(h)(1)-2(e)(2)(ii).
\91\ See proposed rule 211(h)(1)-1 (defining ``gross IRR,''
``net IRR,'' ``gross MOIC,'' and ``net MOIC'').
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The proposed rule also would require an adviser to provide a
statement of contributions and distributions for the illiquid fund. We
believe this would provide private fund investors with important
information regarding the fund's performance because it would reflect
the underlying data used by the adviser to generate the fund's returns,
which, in many cases, is not currently provided to private fund
investors. Such data would allow investors to diligence the various
performance measures presented in the quarterly statement. In addition,
this data would allow the investors to calculate additional performance
measures based on their own preferences.
We propose to define statement of contributions and distributions
as a document that presents:
(i) All capital inflows the private fund has received from
investors and all capital outflows the private fund has distributed to
investors since the private fund's inception, with the value and date
of each inflow and outflow; and
(ii) The net asset value of the private fund as of the end of the
reporting period covered by the quarterly statement.\92\
---------------------------------------------------------------------------
\92\ Proposed rule 211(h)(1)-1.
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For similar reasons to those discussed above, the proposed rule
would require an adviser to prepare the statement of contributions and
distributions without the impact of any fund-level subscription
facilities. This would require an adviser to assume the private fund
called investor capital, rather than drawing down on fund-level
subscription facilities. To avoid double counting capital inflows, the
amount borrowed under the subscription facility generally should be
reflected as a capital inflow from investors and an equal dollar amount
of actual capital inflows from investors generally should not be
reflected on the statement.
Realized and Unrealized Performance. The proposed rule also would
require an adviser to disclose a gross internal rate of return and
gross multiple of invested capital for the realized and unrealized
portions of the illiquid fund's portfolio, with the realized and
unrealized performance shown separately.
The value of the unrealized portion of an illiquid fund's portfolio
typically is determined by the adviser and, given the lack of readily
available market values, can be challenging. For example, an adviser's
valuation policies and procedures for illiquid investments may rely on
models and unobservable inputs. This creates a conflict of interest
because the adviser is typically evaluated and, in certain cases,
compensated based on the fund's unrealized performance. Further,
investors often decide whether to invest in a successor fund based on
the predecessor fund's performance. These factors create an incentive
for the adviser to inflate the value of the unrealized portion of the
illiquid fund's portfolio. We believe highlighting the performance of
the fund's unrealized investments would assist investors in determining
whether the aggregate, fund-level performance measures present an
overly optimistic view of the fund's overall performance. For example,
if the performance of the unrealized portion of the fund's portfolio is
significantly higher than the performance of the realized portion, it
may imply that the adviser's valuations are overly optimistic or
otherwise do not reflect the values that can be realized in a
transaction or sale with an independent third party.
The proposed rule would only require an adviser to disclose gross
performance measures for the realized and unrealized portions of the
illiquid fund's portfolio. We believe that calculating net figures
could involve complex and potentially subjective assumptions regarding
the allocation of fund-level fees, expenses, and adviser compensation
between the realized and unrealized portions of the portfolio.\93\ In
our view, such assumptions would likely diminish the benefits net
performance measures would provide.
---------------------------------------------------------------------------
\93\ For example, an adviser would have to determine how to
allocate fund organizational expenses between the realized and
unrealized portions of the portfolio.
---------------------------------------------------------------------------
We request comment on the following with respect to the proposed
illiquid fund performance requirement:
Are the proposed performance metrics appropriate? Why or
why not? We recognize that advisers often utilize different performance
metrics for different funds. Should we add any other metrics to the
proposed rule? For example, should we require a public market
equivalent or variations of internal rate of return, such as a modified
internal rate of return that assumes cash flows are reinvested at
modest rates of return or otherwise incorporates a cost of capital
concept for funds that do not draw down all, or substantially all, of
investor capital at the time of investment? If so, should we prescribe
a benchmark for the cost of capital and reinvestment rates?
The proposed rule would not distinguish among different
types of illiquid funds. Is our approach in this respect appropriate or
should we treat certain illiquid funds differently? If so, how should
we reflect that treatment?
Are there additional guardrails we should add to the
proposed rule to achieve the policy goal of providing investors with
comparable performance information? If so, please explain. Are there
practices that advisers use or assumptions that advisers make, when
calculating performance that we should require, curtail, or otherwise
require advisers to disclose?
Although some investors receive certain annual performance
information about a private fund if that fund is audited and
distributes financial statements prepared in accordance with U.S. GAAP,
we believe that the proposed rule's performance information would be
helpful for private fund investors because it would require performance
information to be reported at more frequent intervals in a standardized
manner. Do commenters agree? To the extent there are differences (e.g.,
the requirement that performance be computed without the impact of any
fund-level subscription facilities), would investors find this
confusing? Would disclosure regarding these differences help to
alleviate investor confusion?
Would investor confusion or other concerns arise from
requiring performance information in the quarterly statement as
proposed?
What, if any, burdens would be associated with this aspect
of the proposed rule? How can we minimize any associated burdens while
still achieving our goals?
Are the proposed definitions appropriate and clear? If
not, how should we clarify the definitions?
[[Page 16906]]
Should we modify or eliminate any? Would additional definitions be
appropriate or useful? For example, should we define any of the terms
used in the definition of internal rate of return, such as ``net
present value'' or ``discount rate''? If so, what definitions should we
use?
Are the definitions of gross IRR, gross MOIC, net IRR, and
net MOIC appropriate? Should we provide further guidance or specify
requirements in the proposed rule on how to calculate gross performance
or net performance? If so, what guidance or requirements? Should we
require advisers to adopt policies and procedures prescribing specific
methodologies for calculating gross performance and net performance?
Why or why not? When calculating net performance, are there additional
fees and expenses that advisers should include? Alternatively, should
we expressly permit advisers to exclude certain fees and expenses when
calculating net performance figures, such as taxes incurred to
accommodate certain, but not all, investor preferences? Why or why not?
Similarly, are the definitions of gross IRR and gross MOIC
appropriate for purposes of calculating the performance metrics of the
realized and unrealized portions of the illiquid fund's portfolio?
Should we modify such definitions to reference specifically the
realized and unrealized portions of the portfolio, rather than only
referencing the illiquid fund? For example, should the definition of
MOIC be revised to mean, as of the end of the applicable calendar
quarter: (i) The sum of (A) the unrealized value of applicable portion
of the illiquid fund's portfolio, and (b) the value of all
distributions made by the illiquid fund attributable to the applicable
portion of the illiquid fund's portfolio; (ii) divided by the total
capital contributed to the illiquid fund by its investors attributable
to the applicable portion of the illiquid fund's portfolio? Are there
other variations we should impose? Why or why not?
The Global Investment Performance Standards (``GIPS'') are
a set of voluntary standards for calculating and presenting investment
performance. For purposes of calculating an illiquid fund's performance
under the proposed rule, are there any elements found in the GIPS
standards that we should require? For example, should we require
advisers to disclose composite cumulative committed capital,\94\ or
should we require advisers to disclose performance with and without the
impact of subscription facilities? Are there any definitions we should
revise or propose to be consistent with the definitions used in the
GIPS standards? For example, the GIPS standards define ``internal rate
of return'' as the return for a period that reflects the change in
value and the timing and size of external cash flows and ``multiple of
invested capital'' as the total value divided by since inception paid-
in capital.\95\ If we were to adopt such definitions, do commenters
believe that such definitions would result in different performance
numbers for illiquid funds, as compared to the performance numbers that
advisers would disclose under the proposed definitions? Why or why not?
Please provide examples.
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\94\ The GIPS standards define ``committed capital'' as pledges
of capital to an investment vehicle by investors (limited partners
and the general partner) or the firm. The term ``composite'' is
defined as an aggregation of one or more portfolios that are managed
according to a similar investment mandate, objective, or strategy.
The term cumulative is not defined in the GIPS standards. Global
Investment Performance Standards (GIPS) For Firms: Glossary, CFA
Institute (2020), available at https://www.cfainstitute.org/-/media/documents/code/gips/2020-gips-standards-firms.pdf.
\95\ Internal rate of return is referred to as money-weighted
return in the GIPS standards, and multiple of invested capital is
referred to as investment multiple.
---------------------------------------------------------------------------
We recognize that advisers and their related persons
typically invest in private funds on a ``fee-free, carry-free'' basis
(i.e., they are not required to pay management fees or performance-
based compensation). When calculating a fund's performance, how should
such interests be taken into account? Should we require advisers to
exclude such interests from the calculations, especially the net
performance figures?
The proposed rule would require advisers to calculate the
various performance measures without the impact of any fund-level
subscription facilities. Do commenters agree with this approach? Should
the proposed rule require advisers to provide the same performance
measures with the impact of fund-level subscription facilities? Why or
why not? The proposed rule does not prohibit advisers from providing
the same performance measures with the impact of fund-level
subscription facilities. Should we prohibit advisers from doing so?
Should we define the term ``computed without the impact of
any fund-level subscription facilities''? Should we provide additional
guidance or requirements regarding how advisers generally should or
must calculate such performance measures? If so, what guidance or
requirements should we provide?
We recognize that a fund-level subscription facility has
the potential to have a greater impact on a fund's internal rate of
return as compared to its multiple of invested capital. Should advisers
only be required to provide ``unlevered'' internal rates of return and
not ``unlevered'' multiples of invested capital? If the fund realizes
an investment prior to calling any capital from investors in respect of
such investment, how would an adviser calculate a multiple for such
investment?
The proposed rule would require advisers to prepare the
statement of contributions and distributions without the impact of any
fund-level subscription facilities. Would this information be helpful
for investors? Would advisers be able to prepare such a statement
without making arbitrary assumptions? Why or why not? For example,
would advisers need to make assumptions in calculating the preferred
return (if applicable)?
The proposed rule would require only gross performance
measures for the realized and unrealized portion of the illiquid fund's
portfolio. Should the proposed rule require net performance information
as well? Would net performance measures be beneficial for investors
despite the drawbacks discussed above? What assumptions should we
require in calculating net information? What limitations, if any, would
advisers face in providing net performance measures?
Should we define the phrases ``unrealized portion of the
illiquid fund's portfolio'' and ``realized portion of the illiquid
fund's portfolio''? For example, should we define the realized portion
to include not only completely realized investments but also
substantially realized investments to the extent the fund's remaining
interest is de minimis? Why or why not?
Should we require advisers to disclose the dollar amounts
of the realized and unrealized portions of the portfolio? Should we
also require advisers to disclose such amounts as percentages? For
example, if the value of the realized portion of the portfolio is $250
million and the value of the unrealized portion is $750 million, should
we require advisers to disclose those amounts, both as dollar values
and percentages (i.e., 25% ($250 million) of the illiquid fund's
portfolio is realized, and 75% ($750 million) remains unrealized)?
The proposed rule would require advisers to provide
cumulative performance reporting since inception of the illiquid fund
each quarter. Is this the right approach? Should the proposed rule
require performance since inception for each quarter or on an
[[Page 16907]]
annual basis? Should the proposed rule remove the ``since inception''
requirement for quarterly reports and instead require performance for
each quarter of the current year, and cumulative performance for the
current year? If so, why or why not?
Should we prescribe specific periods for illiquid fund
performance reporting? For example, should we prescribe one-, five-,
and/or ten-year time periods? Instead, should we require that advisers
always present performance since inception as proposed? Are there other
periods for which we should require the presentation of performance
results? Are there any specific compliance issues that an adviser would
face in generating and presenting performance results for the required
period? For example, would advisers have the requisite information to
generate or support performance figures for older funds from the
proposed recordkeeping requirements and/or performance presentation
requirements? If not, should we provide an exemption for advisers that
lack such information?
Liquid funds often have longer terms than illiquid funds.
To the extent an illiquid fund has been in existence for an extended
period of time, such as more than ten years, should the rule prescribe
specific periods for performance reporting for such funds (e.g., one-,
five-, and/or ten-year time periods)?
Should we require that advisers provide performance
results current through the end of the quarter covered by the quarterly
statement as proposed? In circumstances where quarter-end numbers are
not available at the time of distribution of the quarterly statement,
should we require an adviser to include performance measures through
the most recent practicable date as proposed? Should we define, or
provide additional guidance about, the term ``most recent practicable
date''? If so, what definition or additional guidance should we
provide?
Should the proposed rule require advisers to make certain,
standard disclosures tailored to each of the performance metrics
mandated in the proposed rule? For example, should we require advisers
to illiquid funds that are required to display internal rate of return
to disclose prominently that the returns do not represent returns on
the investor's capital commitment and instead only reflect returns on
the investor's contributed capital? Should we require advisers to
disclose that an investor's actual return on its capital commitment
will depend on how the investor invests its uncalled commitments?
As noted above, we would generally interpret the phrase
computed without the impact of fund-level subscription facilities to
require advisers to exclude fees and expenses associated with the
subscription facility, such as the interest expense, when calculating
net performance figures and preparing the statement of contributions
and distributions. Do commenters agree with this approach? Should we
require advisers to include such amounts instead? Are there other
assumptions advisers would need to make in calculating performance
information that the rule should address?
The proposed rule would require the statement of
contributions and distributions to reflect the private fund's net asset
value as of the end of the applicable quarter. Should we require
advisers to provide additional detail regarding the unrealized value of
the private fund? For example, should we require advisers to reflect
the portion of such net asset value that would be required to be paid
to the adviser as performance-based compensation assuming a
hypothetical liquidation of the fund?
The statement of contributions and distributions generally
reflects aggregate, fund-level numbers. Should we also require a
statement of contributions and distributions for each underlying
investment? Would a statement of each investment's cash flows be useful
to investors? Why or why not? Would such a requirement be too
burdensome for certain advisers, especially advisers to private funds
that have a significant number of investments? Should this requirement
only apply to certain types of funds, such as private equity, venture
capital, or other similar funds that may invest in operating companies?
Should we provide further guidance or specify requirements
on how advisers generally should or must present performance? For
example, should we require advisers to present the various performance
metrics with equal prominence as proposed? Should we require advisers
to present performance information in a format designed to facilitate
comparison? Should we provide additional guidance or requirements
regarding how an adviser should or must calculate the proposed
performance metrics? Is there additional information that we should
require advisers to disclose when presenting performance?
Should we provide further guidance or specify requirements
in the rule on how advisers generally should or must treat taxes for
purposes of calculating performance? For example, should the rule state
that advisers may exclude taxes paid or withheld with respect to a
particular investor or by a blocker corporation (but not the illiquid
fund as a whole)?
c. Prominent Disclosure of Performance Calculation Information
The proposed rule would require advisers to include prominent
disclosure of the criteria used and assumptions made in calculating the
performance. Information about the criteria used and assumptions made
would enable the private fund investor to understand how the
performance was calculated and help provide useful context for the
presented performance metrics. Additionally, while the proposed rule
includes detailed information about the type of performance an adviser
must present for liquid and illiquid funds, it is still possible that
advisers would make certain assumptions or rely on specific criteria
that the proposed rule's requirements do not address specifically.
For example, the proposed rule would require an adviser to display,
for a liquid fund, the annual returns for each calendar year since the
fund's inception. If the adviser made any assumptions in performing
that calculation, such as whether dividends were reinvested, the
adviser should disclose those assumptions in the quarterly statement.
As another example, for an illiquid fund, the proposed rule would
require an adviser to display the net internal rate of return and net
multiple of invested capital. In this case, the adviser should disclose
the assumed fee rates, including whether the adviser is using fee rates
set forth in the fund documents, whether it is using a blended rate or
weighted average that would factor in any discounts, or whether it is
using a different method for calculating net performance. The proposed
rule requires the disclosure to be within the quarterly statement.\96\
Thus, an adviser may not provide the information only in a separate
document, website hyperlink or QR code, or other separate
disclosure.\97\ We believe that this information is integral to the
quarterly statement because it would enable the investor to understand
and analyze the performance information better and better compare the
performance of funds and advisers
[[Page 16908]]
without having to access other ancillary documents. As a result,
investors should receive it as part of the quarterly statement itself.
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\96\ Proposed rule 211(h)(1)-2(e)(2)(iii).
\97\ See also Marketing Release, supra at footnote 61
(discussing clear and prominent disclosures in the context of
advertisements).
---------------------------------------------------------------------------
We request comment on this aspect of the proposal:
Should we require advisers to disclose the criteria used
and assumptions made in calculating the performance as part of the
quarterly statement as proposed? Is this approach too flexible? Should
we instead prescribe required disclosures?
Should we require advisers to provide these disclosures
prominently as proposed? Is there another disclosure standard we should
use for these purposes?
Because we propose to require an adviser to provide these
disclosures as part of each quarterly statement, investors would
receive these disclosures quarterly. Would providing these disclosures
every quarter reduce their salience? Should we require these
disclosures only as part of the first quarterly statement that an
adviser sends to an investor with amendments if the criteria used or
assumptions made in calculating performance change? Should we permit
hyperlinking to these disclosures after the initial quarterly
statement?
3. Preparation and Distribution of Quarterly Statements
The proposed rule would require quarterly statements to be prepared
and distributed to fund investors within 45 days after each calendar
quarter end. We believe quarterly statements would provide fund
investors with timely and regular statements that contain meaningful
and comprehensive information. We understand that most private fund
advisers currently provide investors with quarterly reporting.\98\
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\98\ See also ILPA Fee Reporting Template Guidance, Version 1.1
(Oct. 2016), at 6 (stating that ``ILPA recommends that the Template
is provided on a quarterly basis within a reasonable timeframe after
the release of standard reports.'').
---------------------------------------------------------------------------
For a newly formed private fund, the proposed rule would require a
quarterly statement to be prepared and distributed beginning after the
fund's second full calendar quarter of generating operating results.
Many private funds may not have performance information that is readily
available within the first several months of operations. For example, a
private equity fund might not begin investing until several months
after the fund's formation because the adviser is still identifying
investments that align with the fund's strategy. As another example, a
hedge fund may hold initial investor capital in cash or cash
equivalents, prior to commencing the fund's investment strategy.
Accordingly, we believe that the proposed requirements for newly formed
funds would help ensure that investors receive comprehensive
information about the adviser during the early stage of the fund's
life. The reporting period for the final quarterly statement would
cover the calendar quarter in which the fund is wound up and dissolved.
We propose to require quarterly statements to be distributed within
45 days after the calendar quarter end. Based on our experience, we
believe advisers generally would be in a position to prepare and
deliver quarterly statements within this period.
An adviser generally would satisfy the proposed requirement to
``distribute'' the quarterly statements when the statements are sent to
all investors in the private fund.\99\ However, the proposed rule would
preclude advisers from using layers of pooled investment vehicles in a
control relationship with the adviser to avoid meaningful application
of the distribution requirement. Advisers to private funds may from
time to time establish special purpose vehicles (``SPVs'') or other
pooled vehicles for a variety of reasons, including facilitating
investments by one or more private funds that the advisers manage. In
circumstances where an investor is itself a pooled vehicle that is
controlling, controlled by, or under common control with the adviser or
its related persons (a ``control relationship''), the adviser must look
through that pool (and any pools in a control relationship with the
adviser or its related persons, such as in a master-feeder fund
structure), in order to send to investors in those pools. Without such
a requirement, the adviser would be essentially delivering the
quarterly statement to itself rather than to the parties the quarterly
statement is designed to inform.\100\ Outside of a control
relationship, such as if the private fund investor is an unaffiliated
fund of funds, this same concern is not present, and the adviser would
not need to look through the structure to make meaningful delivery. The
adviser would just distribute the quarterly statement to the adviser or
other designated party of the unaffiliated fund of funds. We believe
that this approach would lead to meaningful delivery of the quarterly
statement to the private fund's investors.
---------------------------------------------------------------------------
\99\ See proposed rule 211(h)(1)-1 (defining ``distribute'').
For purposes of the proposed rules, any ``in writing'' requirement
could be satisfied either through paper or electronic means
consistent with existing Commission guidance on electronic delivery
of documents. See Marketing Release, supra footnote 61, at n.346. If
any distribution is made electronically for purposes of these
proposed rules, it should be done in accordance with the
Commission's guidance regarding electronic delivery. See Use of
Electronic Media by Broker Dealers, Transfer Agents, and Investment
Advisers for Delivery of Information; Additional Examples Under the
Securities Act of 1933, Securities Exchange Act of 1934, and
Investment Company Act of 1940, Release No. 34-37182 (May 9, 1996)
[61 FR 24644 (May 15, 1996)].
\100\ See proposed rule 211(h)(1)-1 (defining ``control'').
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We request comment on the quarterly statement preparation and
distribution requirement of the proposed rule:
Should we require advisers to prepare and distribute
statements to clients at least quarterly, or should we prescribe a
different frequency? For example, should we require monthly, semi-
annual, or annual statements? Should we mandate the same delivery
frequency for all proposed statements under the rule? How would each of
these approaches affect comparability and effectiveness of the
information in those statements? Would a quarterly reporting obligation
require advisers to value the fund's investments more frequently than
advisers currently do?
We understand that advisers may use a fund administrator
or another person to distribute the quarterly statement. Is the
proposed definition of ``distribute'' broad enough to capture a fund
administrator or another person acting under the direction and control
of the adviser sending the quarterly statement on the adviser's behalf?
If not, should we broaden the definition? Instead of changing the
definition of ``distribute,'' should we require the adviser to
distribute the quarterly statement, unless it has reason to believe
that another person has distributed a required statement (and has a
copy of each such statement distributed by such other person)?
The proposed rule would require advisers to distribute the
quarterly statement within 45 days of a calendar quarter end. Is this
period too long or too short for an adviser to prepare the quarterly
statement while also ensuring timely delivery to investors? Should we
instead adopt a flexible delivery standard, such as a requirement that
the adviser distribute the quarterly statement ``promptly''? Why or why
not? If we were to adopt a prompt delivery standard, should we define
``promptly''? If so, how? If we should not define ``promptly,'' should
we instead interpret that term to mean as soon as reasonably
practicable?
We understand that preparing quarterly statements may
require coordination with, and reliance on, third parties. This may be
the case, for example, when a private fund itself invests in other
private funds or
[[Page 16909]]
portfolio companies. Should the rule allow different distribution
timelines for different types of private funds (e.g., fund of funds,
master feeder funds)? If so, why (e.g., do certain types of funds value
assets more frequently than other types)? Should the proposed rule
allow different distribution deadlines for underlying funds, depending
on whether or not the underlying funds have the same adviser or an
adviser that is a related person of the adviser distributing the
quarterly statements?
Should the proposed rule bifurcate the timing of when
certain information in the quarterly statement is required? For
example, should the proposed rule require fee and expense information
starting at the fund's inception and then require performance
information beginning later? If so, when should we require an adviser
to start showing performance?
Should the proposed rule treat liquid and illiquid funds
differently with regard to fee and expense versus performance
reporting? For example, should the proposed rule require liquid funds
to start distributing quarterly statements with performance reporting
sooner than illiquid funds? If so, why and how much sooner?
As proposed, the rule would use ``operating results'' as
the trigger for quarterly statement distribution. Should we instead
rely on another trigger to indicate when an adviser must start
distributing quarterly statements to investors? For example, should the
proposed rule instead require an adviser to start distributing
quarterly statements when the private fund has financial statements
that report operating results? If so, why? Should we define ``operating
results'' or clarify what it means?
Should the proposed rule require an adviser to prepare and
distribute an initial quarterly statement sooner than after the first
two full calendar quarters of operating results? For example, should we
require an adviser to prepare and distribute a quarterly statement
after the first calendar quarter of the fund's operations? Why or why
not? If we required an adviser to prepare and distribute a quarterly
statement earlier in the fund's life, would this information be useful
to investors?
The proposed rule would require advisers to prepare and
distribute a quarterly statement after the private fund has two full
calendar quarters of operating results and continuously each calendar
quarter thereafter. An adviser would be required to provide information
for any stub periods that precede its first two full calendar quarters
of operating results (i.e., from the date of the fund's inception to
the beginning of the first calendar quarter during which the fund
begins to produce operating results). Should the proposed rule
explicitly address how advisers should handle stub periods? If so, how?
The proposed rule would require fee and expense reporting
based on a fund's calendar quarter and performance reporting based on a
liquid fund's calendar year. Should we instead use ``fiscal quarter''
and ``fiscal year''? Why or why not?
Are there certain types of advisers or funds that should
be exempt from distributing the quarterly statement to investors? If
so, which ones and why? Are there certain types of advisers or funds
that should be required to distribute quarterly statements to
investors? If so, which ones and why?
Instead of requiring advisers to distribute the quarterly
statement to investors, should we require advisers to only distribute
or make the quarterly statement available to investors upon request?
Despite the limitations of private fund governance mechanisms, as
discussed above, should we require advisers to distribute the quarterly
statement to independent members of the fund's LPAC, board, or other
similar governance body?
Rule 206(4)-2 under the Advisers Act (the ``custody
rule'') allows a client to designate an independent representative to
receive on its behalf account statements and notices that are required
by that rule.\101\ Under the custody rule, an ``independent
representative'' is defined as someone who does not control, is not
controlled by, and is not under common control with the adviser, among
other requirements.\102\ Should we adopt a similar provision in the
quarterly statement rule? Are there specific types of investors that
need, or at present commonly designate, independent representatives to
receive quarterly statements on their behalf?
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\101\ See rule 206(4)-2(a)(7) under the Advisers Act.
\102\ See rule 206(4)-2(d)(4) under the Advisers Act.
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Should we revise the definition of ``distribute''
expressly to include distribution by granting investors access to a
virtual data room containing the quarterly statement? Why or why not?
We considered requiring the proposed quarterly statement
disclosures to be submitted using a structured, machine-readable data
language. Such format may facilitate comparisons of quarterly statement
disclosures across advisers and periods. Should we require advisers to
provide quarterly statements in a machine-readable data language, such
as Inline eXtensible Business Reporting Language (``Inline XBRL'')? Why
or why not? Would such a requirement make the quarterly statements, and
the information included therein, easier for investors to analyze? For
example, would it be useful for investors to download quarterly
statement information directly into spreadsheets, particularly for
institutional investors that may have a significant number of private
fund investments? Would a machine-readable data language impose undue
additional costs and burdens on advisers? Please provide support for
your response, including, where available, cost data.
If we adopt rules requiring a machine-readable data
language, is the Inline XBRL standard the one that we should use? Are
any other standards becoming more widely used or otherwise superior to
Inline XBRL? What would the advantages of any such other standards be
over Inline XBRL?
4. Consolidated Reporting for Certain Fund Structures
An adviser may form multiple funds to implement a single strategy.
For example, an adviser may form a parallel fund for certain tax-
sensitive investors, such as non-U.S. investors that prefer to invest
through an entity taxed as a corporation--rather than a partnership--
for U.S. Federal income tax purposes, that invests alongside the main
fund in all, or substantially all, of its investments. An adviser may
also form a feeder fund for tax-sensitive investors that invests all,
or substantially all, of its capital into the main fund. Advisers often
seek to structure the funds in a way that accommodates investor
preferences.
In some of these circumstances, we believe that consolidated
reporting of the cost and performance information by all private funds
in the structure would provide a more complete and accurate picture of
the fees and expenses borne and performance achieved than reporting by
each private fund separately. Due to the complexity of private fund
structures, however, we believe a principles-based approach to the
funds that must provide consolidated reporting is necessary.
Accordingly, the proposed rule would require advisers to consolidate
reporting for substantially similar pools of assets to the extent doing
so would provide more meaningful information to the
[[Page 16910]]
private fund's investors and would not be misleading.\103\
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\103\ See proposed rule 211(h)(1)-2(f). See also infra Section
II.E.
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For example, certain private funds utilize master-feeder
structures. Typically, investors invest in onshore and offshore feeder
funds, which, in turn, invest all, or substantially all, of their
investable capital in a single master fund. The same adviser typically
advises and controls all three funds, and the master fund typically
makes and holds the investments. Because the feeder funds are conduits
for investors to gain exposure to the master fund and its investments,
the proposed rule would require the adviser to provide feeder fund
investors with a single quarterly statement covering the applicable
feeder fund and the feeder fund's proportionate interest in the master
fund on a consolidated basis, so long as the consolidated statement
would provide more meaningful information to investors and would not be
misleading.
We request comment on the proposed consolidated reporting provision
of the proposed rule:
Do commenters agree that the proposed rule should require
advisers to consolidate reporting to cover related funds to the extent
doing so would provide more meaningful information to investors and
would not be misleading? Alternatively, should we prohibit advisers
from consolidating information for multiple funds? Why or why not?
Should the rule permit, rather than require, consolidated reporting?
Should we require advisers to provide a consolidated
quarterly statement for funds that are part of the same strategy, such
as parallel funds, feeder funds, and master funds? Alternatively,
should these types of funds have separate reporting? For example,
should feeder fund investors receive a quarterly statement covering the
feeder fund and a separate quarterly statement covering the main fund
or master fund? How should the rule address the fact that certain funds
may have different expenses (e.g., an offshore fund may have director
expenses while an onshore fund may not)? Should we require advisers to
provide investors with a summary of any fund-specific expenses and the
corresponding dollar amount(s)? Should such a requirement be triggered
only if the fund-specific expense exceeds a certain threshold, such as
a percentage of the fund size (e.g., .01%, .05%, or .10% of the fund's
size) or a specific dollar amount (e.g., $15,000, $30,000, or $50,000)?
As noted above, the proposal would require advisers to
provide feeder fund investors with a consolidated quarterly statement
covering the applicable feeder fund and the feeder fund's proportionate
interest in the master fund, to the extent doing so would provide more
meaningful information to investors and would not be misleading. Do
commenters agree with this approach? Alternatively, should we require
advisers to provide consolidated reporting covering all feeder funds
(and not just the applicable feeder fund) and the master fund? Why or
why not?
We also recognize that certain private funds have multiple
classes (or other groupings such as series or tranches) of interests or
shares. The proposed rule would require the quarterly statement to
present fund-wide information. Would advisers face challenges in
calculating fee, expense, and performance information if there are
differences in fees, allocations, and/or expenses between or among
classes, series, or tranches? Should we require disclosure of class-
specific fees and expenses, or of the differences among classes? Why or
why not? Should we instead permit or require quarterly statements for
multi-class private funds to present the proposed fee and expense and
performance information on a class-by-class basis, particularly if each
class (or series or tranche) is considered a distinct private fund or
separate legal entity (with segregated assets and liabilities) under
applicable law? Would such an approach provide more meaningful
information for investors in each of those classes, given the potential
for different fee, allocation, and expense structures? Should we
require quarterly statements for multi-class (or multi-series or multi-
tranche) private funds to present class-by-class (or series-by-series
or tranche-by-tranche) information to the extent each class (or series
or tranche) holds different investments?
Should advisers only be required to distribute a class'
quarterly statement to interest holders of such class, or should all
fund investors be entitled to receive such statement regardless of
whether they are interest holders of the relevant class if the rule
permits or requires class-specific quarterly statements for multi-class
private funds?
Certain advisers provide combined financial statements
covering multiple funds. Should we require or permit advisers to
provide consolidated quarterly statements for funds that have combined
financial statements? Why or why not?
5. Format and Content Requirements
The proposed rule would require the adviser to use clear, concise,
plain English in the quarterly statement.\104\ For example, an adviser
would not satisfy the proposed requirement for ``clear'' disclosures
unless those disclosures are made in a font size and type that is
legible, and margins and paper size (if applicable) are reasonable.
Likewise, to meet this standard, any information that an adviser
chooses to include in a quarterly statement, but that is not required
by the rule, would be required to be as short as practicable, not more
prominent than the required information, and not obscure or impede an
investor's understanding of the mandatory information.
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\104\ Proposed rule 211(h)(1)-2(g).
---------------------------------------------------------------------------
In addition, the proposed rule would require an adviser to present
information in the quarterly statement in a format that facilitates
review from one quarterly statement to the next. As noted above, the
quarterly statement is designed to allow an investor to monitor and
assess the costs and performance of the fund over time. We anticipate
that, quarter-over-quarter, an adviser would use a consistent format
for a fund's quarterly statements, thus allowing an investor to easily
compare fees, expenses, and performance over each quarterly period. We
also encourage advisers to use a structured, machine-readable format if
advisers believe this format would be useful to the investors in their
fund.
The proposed format and content requirements would apply to all
aspects of a quarterly statement, including the proposed requirements
to disclose the manner in which expenses, payments, allocations,
rebates, waivers, and offsets are calculated and to cross-reference
sections of the private fund's organizational and offering
documents.\105\ We believe this approach would improve the utility of
the quarterly statement by making it easier for investors to review and
analyze. These requirements would support an investor's ability to
understand needed context provided in the quarterly statement regarding
fees, expenses, and performance that allows investors to monitor their
investments. For example, providing investors with clear and easily
accessible cross-references to the fund governing documents would make
it easier for the investor to monitor whether the fees and expenses in
the quarterly statement comply with the fund's governing documents.
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\105\ Proposed rule 211(h)(1)-2(d).
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We believe the proposal strikes an appropriate balance in
prescribing the
[[Page 16911]]
content of the tables and performance information to be included in
quarterly statements while taking a fairly principles-based approach to
format. This would help provide investors with standardized information
about their private fund investments, while affording advisers some
flexibility to present the required information without being overly
prescriptive or sacrificing readability. We considered, but are not
proposing, to further standardize format, because we recognize this
might result in investor confusion if an adviser includes inapplicable
line items to satisfy our form requirements, while omitting additional
relevant information that might be unique to a particular fund.
Moreover, we were concerned that advisers would be unable to report on
a consolidated basis if we further prescribed the format of the
statements.
We request comment on this aspect of the proposed rule:
Should the proposed quarterly statement rule include a
provision on formatting and content? Why or why not?
Do commenters agree with the flexibility of the proposed
format and content requirements, or should we prescribe wording? For
example, should we require a cover page with prescribed wording? If so,
what prescribed wording should we require?
To meet the rule's formatting requirements, any
information that an adviser chooses to include in a quarterly
statement, but that is not required by the rule, would be required to
be presented in a manner that is no more prominent than the required
information. Should the rule, instead, require that advisers more
prominently present information that is required by the proposed
quarterly statement rule (as opposed to supplemental information that
is merely permitted)? If an adviser chooses to include supplemental
information, should we require that adviser to disclose what
information in the quarterly statement is required versus that which is
voluntary?
6. Recordkeeping for Quarterly Statements
We propose amending rule 204-2 (the ``books and records rule'')
under the Advisers Act to require advisers to retain books and records
related to the proposed quarterly statement rule.\106\ These proposed
amendments would help facilitate the Commission's inspection and
enforcement capabilities. First, we propose to require private fund
advisers to retain a copy of any quarterly statement distributed to
fund investors pursuant to the proposed quarterly statement rule, as
well as a record of each addressee, the date(s) the statement was sent,
address(es), and delivery method(s). Second, we propose to require
advisers to retain all records evidencing the calculation method for
all expenses, payments, allocations, rebates, offsets, waivers, and
performance listed on any quarterly statement delivered pursuant to the
proposed quarterly statement rule. Third, advisers would be required to
make and keep books and records substantiating the adviser's
determination that the private fund it manages is a liquid fund or an
illiquid fund pursuant to the proposed quarterly statement rule. We
believe these proposed requirements would facilitate our staff's
ability to assess an adviser's compliance with the proposed rule and
would similarly enhance an adviser's compliance efforts.\107\
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\106\ For all of the recordkeeping rule amendments in this
proposed rulemaking package, advisers would be required to maintain
and preserve the record in an easily accessible place for a period
of not less than five years from the end of the fiscal year during
which the last entry was made on such record, the first two years in
an appropriate office of the investment adviser. See rule 204-
2(e)(1) under the Advisers Act.
\107\ Advisers already are required to retain performance
calculation information under the existing books and records rule
and therefore would be required to retain the performance
calculation information required as part of the proposed quarterly
statement rule. See rule 204-2(a)(16) under the Advisers Act
(requiring advisers to retain performance calculation information).
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We request comment on the proposed recordkeeping rule amendments:
Should we require advisers to maintain the proposed
records or would these requirements be overly burdensome for advisers?
Are there alternative or additional recordkeeping requirements we
should impose?
Should we require advisers to retain a record of each
addressee, the date(s) the statement was sent, address(es), and
delivery method(s) for each quarterly statement, as proposed? Should we
instead eliminate this requirement because of the potential burdens?
Should we provide more specific requirements regarding the
records an adviser must maintain to substantiate its determination that
a private fund is a liquid fund or an illiquid fund? Alternatively,
should we leave the proposed rule as is and allow advisers flexibility
in how they document this determination?
B. Mandatory Private Fund Adviser Audits
In addition to disclosure, we propose to require private fund
advisers to obtain an annual audit of the financial statements of the
private funds they manage.\108\ In addition to providing protection for
the fund and its investors against the misappropriation of fund assets,
we believe an audit by an independent public accountant would provide
an important check on the adviser's valuation of private fund assets,
which often serve as the basis for the calculation of the adviser's
fees.
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\108\ Proposed rule 206(4)-10. The proposed rule would apply to
all investment advisers registered, or required to be registered,
with the Commission.
---------------------------------------------------------------------------
The proposed audit rule would require a registered investment
adviser providing investment advice, directly or indirectly, to a
private fund, to cause that fund to undergo a financial statement audit
that meets the terms of the rule at least annually and upon
liquidation, unless the fund otherwise undergoes such an audit. Under
the proposed rule:
(1) The audit must be performed by an independent public accountant
that meets the standards of independence in 17 CFR 210.2-01(b) and (c)
(rule 2-01(b) and (c) of Regulation S-X) that is registered with, and
subject to regular inspection as of the commencement of the
professional engagement period, and as of each calendar year-end, by,
the Public Company Accounting Oversight Board (``PCAOB'') in accordance
with its rules;
(2) The audit must meet the definition of audit in 17 CFR 210.1-
02(d) (rule 1-02(d) of Regulation S-X), the professional engagement
period of which shall begin and end as indicated in Regulation S-X rule
2-01(f)(5);
(3) Audited financial statements must be prepared in accordance
with U.S. Generally Accepted Accounting Principles (``U.S. GAAP'') or,
in the case of financial statements of private funds organized under
non-U.S. law or that have a general partner or other manager with a
principal place of business outside the United States (``foreign
private funds''), must contain information substantially similar to
statements prepared in accordance with U.S. GAAP and material
differences with U.S. GAAP must be reconciled;
(4) Promptly after completion of the audit, the private fund's
audited financial statements, which include any reconciliation to U.S.
GAAP prepared for a foreign private fund, are distributed; and
(5) The auditor notifies the Commission upon certain events.\109\
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\109\ Proposed rule 206(4)-10; proposed rule 211(h)(1)-1
(defining ``control'' and ``distributed'').
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Additionally, for a fund that the adviser does not control and that
is neither controlled by nor under
[[Page 16912]]
common control with the adviser (e.g., where an unaffiliated sub-
adviser provides services to the fund), such adviser would only need to
take all reasonable steps to cause the fund to undergo an audit that
would meet these elements.
We have historically relied on financial statement audits to verify
the existence of pooled investment vehicle investments.\110\ Financial
statement audits also provide additional meaningful protections to
private fund investors by increasing the likelihood that fraudulent
activity or problems with valuation are uncovered, thereby providing
deterrence against fraudulent conduct by fund advisers. For example as
noted above, a fund's adviser may use a high level of discretion and
subjectivity in valuing a private fund's illiquid investments, which
are difficult to value. This creates a conflict of interest if the
adviser also calculates its fees as a percentage of the value of the
fund's investments and/or an increase in that value (net profit), as is
typically the case. Moreover, private fund advisers often rely heavily
on existing fund performance when obtaining new investors (in the case
of a private fund that makes continuous or periodic offerings) or
fundraising for a new fund. These factors raise the possibility that
funds are valued opportunistically and that the adviser's compensation
may involve fraud or deception, resulting in an inappropriate
compensation scheme.\111\ A fund audit includes the evaluation of
whether the fair value estimates and related disclosures are reasonable
and consistent with the requirements of the financial reporting
framework (e.g., U.S. GAAP), which may include evaluating the selection
and application of methods, significant assumptions, and data used by
the adviser in making the estimate.\112\ We believe that this would
provide a critical set of additional protections by an independent
third party.
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\110\ See, e.g., rule 206(4)-2(b)(4) under the Advisers Act;
Custody of Funds or Securities of Clients by Investment Advisers,
Investment Advisers Act Release No. 2176 (Sept. 25, 2003) [68 FR
56692 (Oct. 1, 2003)] (``Custody Release'') (providing advisers to
certain pooled investment vehicles with an exception to the surprise
examination requirement if the pooled investment vehicles undergo an
audit). Not all advisers are subject to the custody rule and even
those that are subject to the custody rule are not required to
obtain an audit in order to comply with the rule.
\111\ See generally Jenkinson, Sousa, Stucke, How Fair are the
Valuations of Private Equity Funds? (2013), available at https://www.psers.pa.gov/About/Investment/Documents/PPMAIRC%202018/27%20How%20Fair%20are%20the%20Valuations%20of%20Private%20Equity%20Funds.pdf. See also In the Matter of Swapnil Rege, Investment Advisers
Act Release No. 5303 (July 18, 2019) (settled action) (alleging that
an employee of a private fund adviser mispriced the private fund's
investments, which resulted in the adviser charging the fund excess
management fees); SEC v. Southridge Capital Mgmt., LLC, Lit. Rel.
No. 21709 (Oct. 25, 2010) (alleging that adviser overvalued the
largest position held by the funds by fraudulently misstating the
acquisition price of the assets); see docket for SEC v. Southridge
Capital Mgmt., LLC, U.S. District Court, District of Connecticut
(New Haven), case no. 3:10-CV-01685 (on September 12, 2016 the court
granted the SEC's motion for summary judgment and entered a final
judgment in favor of the SEC in 2018).
\112\ See American Institute of Certified Public Accountants'
(``AICPA'') auditing standards, AU-C Section 540 and PCAOB auditing
standards, AS 2501.
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The proposed audit rule is based on the custody rule and contains
many similar or identical requirements, although compliance with either
rule would not automatically satisfy the requirements of the
other.\113\ Although the financial statement audit performed under
either rule would be the same, there are several differences between
the two rules. The most notable difference between the two rules is the
lack of choice about obtaining an audit under the proposed audit rule.
Under the custody rule, an adviser is deemed to have satisfied that
rule's annual surprise examination requirement for a pooled investment
vehicle client if that pool is subject to an annual financial statement
audit by an independent public accountant, and its audited financial
statements (prepared in accordance with generally accepted accounting
principles) are distributed to the pool's investors. Accordingly, an
adviser may obtain a surprise examination under the custody rule
instead of an audit. Private fund advisers complying with the proposed
audit rule would not have a similar choice; they must obtain an audit.
Based on our experience since introducing the custody rule's audit
provision, we have come to believe that audits provide substantial
benefits to private funds and their investors because audits test
assertions associated with the investment portfolio (e.g.,
completeness, existence, rights and obligations, valuation,
presentation). Audits may also provide a check against adviser
misrepresentations of performance, fees, and other information about
the fund. Accordingly, the proposed audit rule would require registered
private fund advisers, including those that currently opt to undergo a
surprise examination for custody rule compliance purposes, to have
their private fund clients undergo a financial statement audit.
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\113\ See rule 206(4)-2(b)(4) under the Advisers Act.
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Another main difference between the requirements of the two rules
is the requirement of the proposed rule for there to be a written
agreement between the adviser or the private fund and the auditor
pursuant to which the auditor would be required to notify our Division
of Examinations upon the auditor's termination or issuance of a
modified opinion.\114\ There is not a similar obligation under the
custody rule for an adviser that relies on the audit provision to
satisfy the surprise examination requirement. Our experience in
receiving similar information from accountants who perform surprise
examinations under the custody rule has led us to conclude that timely
receipt of this information--from an independent third party--would
more readily enable our staff to identify advisers potentially engaged
in harmful misconduct and who have other compliance issues.\115\ This
also would aid the Commission in its oversight of private fund
advisers.
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\114\ See proposed rule 206(4)-10(e). See AICPA auditing
standard, AU-C Section 705, which establishes three types of
modified opinions: A qualified opinion, an adverse opinion, and a
disclaimer of opinion.
\115\ See rule 206(4)-2(a)(4)(iii) (requiring somewhat similar
information in the context of a surprise examination).
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The other main difference between the two rules, aside from timing
requirements for the distribution of audited financial statements under
the two rules discussed below, relates to their scope. While both rules
pertain to advisers that are registered or required to be registered
with us, the custody rule also contains exceptions from the surprise
examination requirement, which in turn make it unnecessary for an
adviser to rely on that rule's audit provision.\116\ In light of the
different policy goals of these two rules, we are not proposing a
parallel exception to the proposed audit rule. Moreover, in our
experience, private fund advisers generally do not often rely on these
exceptions. The proposed audit rule does, however, contain an exception
in certain contexts where the adviser takes all reasonable steps to
cause an audit, as described and for reasons discussed below, which
does not exist in the custody rule.
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\116\ See rule 206(4)-2(b)(3) and (6) (providing exceptions from
the surprise examination requirement for fee deduction and where the
adviser has custody solely because a related person has custody of a
client's funds or securities).
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1. Requirements for Accountants Performing Private Fund Audits
The proposed audit rule would include certain requirements
regarding the accountant performing a private fund audit. First, we
propose to require an accountant performing a private fund audit to
meet the standards of
[[Page 16913]]
independence described in rule 2-01(b) and (c) of Regulation S-X in
support of the Commission's long-standing recognition that an audit by
an objective, impartial, and skilled professional contributes to both
investor protection and investor confidence.\117\ Second, the proposed
rule would require the independent public accountant performing the
audit to be registered with, and subject to regular inspection as of
the commencement of the professional engagement period, and as of each
calendar year-end, by, the PCAOB in accordance with its rules. Based on
our experience with the custody rule, we believe registration and the
periodic inspection of an independent public accountant's system of
quality control by the PCAOB provide investors with confidence in the
quality of the audits produced under the proposed rule.
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\117\ See Revision of the Commission's Auditor Independence
Requirements, Release No. 33-7919 (Nov. 21, 2000) [65 FR 76008 (Dec.
5, 2000)]. The custody rule requires all accountants performing
services to meet the standards of independence described in rule 2-
01(b) and (c) of Regulation S-X. See rule 206(4)-2(d)(3) under the
Advisers Act.
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We understand that this requirement may limit the pool of
accountants that are eligible to perform these services because only
those accountants that currently conduct public company issuer audits
are subject to regular inspection by the PCAOB. Most private funds,
however, are already undergoing a financial statement audit; therefore,
the increase in demand for these services may be limited.\118\
Nonetheless, the resulting competition for these services might
increase costs to investment advisers and investors.
---------------------------------------------------------------------------
\118\ For example, more than 90 percent of the total number of
hedge funds and private equity funds currently undergo a financial
statement audit. See infra Section V.B.4.
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We understand that, as part of a temporary inspection program, the
PCAOB inspects accountants auditing brokers and dealers, and identifies
and addresses with these firms any significant issues in those
audits.\119\ Similar to the inspection program for issuer audits, we
believe that the temporary inspection program for broker-dealers
provides valuable oversight of these accountants, resulting in better
quality audits. Accordingly, we would consider an accountant's
compliance with the PCAOB's temporary inspection program for auditors
of brokers and dealers to satisfy the requirement for regular
inspection by the PCAOB under the proposed independent public
accountant engagements provision until the effective date of a
permanent program for the inspection of broker and dealer auditors that
is approved by the Commission.\120\
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\119\ See PCAOB Adopts Interim Inspection Program for Broker-
Dealer Audits and Broker and Dealer Funding Rules (June 14, 2011)
(``temporary inspection program''), available at https://pcaobus.org/News/Releases/Pages/06142011_OpenBoardMeeting.aspx. See
also Dodd-Frank Act Section 982.
\120\ Our staff took a similar position and has had several
years to observe the impact on the availability of accountants to
perform services and the quality of services produced by these
accountants. See Robert Van Grover Esq., Seward & Kissel LLP, SEC
Staff No-Action Letter (Dec. 11, 2019) (extending the no-action
position taken in prior letters until the date that a PCAOB-adopted
permanent program, having been approved by the Commission, takes
effect).
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An independent public accounting firm would not be considered to be
``subject to regular inspection'' if it is included on the list of
firms that is headquartered or has an office in a foreign jurisdiction
that the PCAOB has determined it is unable to inspect or investigate
completely because of a position taken by one or more authorities in
that jurisdiction in accordance with PCAOB Rule 6100.\121\ We recognize
that there may be a limited number of PCAOB-registered and inspected
independent public accountants in certain foreign jurisdictions.
However, we do not believe that advisers would have significant
difficulty in finding an accountant that is eligible under the proposed
rule in most jurisdictions because many PCAOB-registered independent
public accountants who are subject to regular inspection currently have
practices in various jurisdictions, which may ameliorate concerns
regarding offshore availability.
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\121\ See, e.g., HFCAA Determination Report Pursuant to 15
U.S.C. 7214(i)(2)(A) and PCAOB Rule 6100 (Dec. 16. 2021), PCAOB
Release No. 104-HFCAA-2021-001, available at 104-hfcaa-2021-001.pdf
(azureedge.net) (publishing such list of firms as of December 2021).
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2. Auditing Standards for Financial Statements
Under the proposed audit rule, an audit must meet the definition in
rule 1-02(d) of Regulation S-X. Pursuant to that definition, financial
statement audits performed for purposes of the proposed audit rule
would generally be performed in accordance with the generally accepted
auditing standards of the United States (``U.S. GAAS'').\122\ U.S. GAAS
requires that an auditor evaluate and respond to the risk of material
misstatements of the financial statements due to fraud or error.\123\
Among other benefits of this standard, audits performed in accordance
with U.S. GAAS would help detect valuation irregularities or errors, as
well as an investment adviser's loss, misappropriation, or misuse of
client investments. The proposed rule would require the professional
engagement period of an audit performed under the rule to begin and end
as indicated in Regulation S-X rule 2-01(f)(5).\124\
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\122\ Under the definition in rule 1-02(d) of Regulation S-X, an
``audit'' of an entity (such as a private fund) that is not an
issuer as defined in section 2(a)(7) of the Sarbanes-Oxley Act of
2007 means an audit performed in accordance with either the
generally accepted auditing standards of the United States (``U.S.
GAAS'') or the standards of the PCAOB. When conducting an audit of
financial statements in accordance with the standards of the PCAOB,
however, the auditor would also be required to conduct the audit in
accordance with U.S. GAAS because the audit would not be within the
jurisdiction of the PCAOB as defined by the Sarbanes-Oxley Act of
2002, as amended, (i.e., not an issuer, broker, or dealer). See
AICPA auditing standards, AU-C Section 700.46. We believe most
advisers would choose to perform the audit pursuant to U.S. GAAS
only rather than both standards, though it would be permissible
under the proposed audit rule to perform the audit pursuant to both
standards.
\123\ See AICPA auditing standards, AU-C Section 240. Audits
performed under PCAOB standards provide similar benefits. See PCAOB
auditing standards, AS 2401, which discusses consideration of fraud
in a financial statement audit.
\124\ Among other things, rule 2-01(f)(5) of Regulation S-X
indicates that the professional engagement period begins at the
earlier of when the accountant either signs an initial engagement
letter (or other agreement to review or audit a client's financial
statements) or begins audit, review, or attest procedures; and the
period ends when the audit client or the accountant notifies the
Commission that the client is no longer that accountant's audit
client.
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3. Preparation of Audited Financial Statements
The proposed rule also generally would require the audited
financial statements to be prepared in accordance with U.S. GAAP.
Financial statements of private funds organized under non-U.S. law or
that have a general partner or other manager with a principal place of
business outside the United States would be required to contain
information substantially similar to statements prepared in accordance
with U.S. GAAP and any material differences would be required to be
reconciled to U.S. GAAP. Requiring that financial statements comply
with U.S. GAAP is designed to help investors receive consistent and
quality financial reporting on their investments from the fund's
adviser.
Financial statements that are prepared in accordance with
accounting standards other than U.S. GAAP, would meet the requirements
of the proposed audit rule so long as they contain information
substantially similar to financial statements prepared in accordance
with U.S. GAAP, material differences with U.S. GAAP are reconciled, and
the reconciliation,
[[Page 16914]]
including supplementary U.S. GAAP disclosures, is distributed to
investors as part of the audited financial statements.\125\ We believe
that this approach would allow advisers flexibility to provide
investors with financial statements that are prepared in accordance
with applicable accounting standards. We believe a reconciliation to
U.S. GAAP is necessary for private fund audits because U.S. GAAP, has
industry specific accounting principles for certain pooled vehicles,
including private funds.\126\ As a result, there could be material
differences between other accounting standards and U.S. GAAP, for
example in the presentation of a trade/settlement date, schedule of
investments and financial highlights, that we would require to be
reconciled.
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\125\ Proposed rule 206(4)-10(c) and (d). See also Custody
Release, supra footnote 110, at n.41 (stating that an adviser may
use such financial statements to qualify for the audit exception
from the custody rule with respect to pools that have a place of
organization outside the United States or a general partner or other
manager with a principal place of business outside the United
States, if such financial statements contain information that is
substantially similar to financial statements prepared in accordance
with U.S. GAAP and contain a footnote reconciling any material
variations between such comprehensive body of accounting standards
and U.S. GAAP).
\126\ See U.S. GAAP ASC 946.
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4. Prompt Distribution of Audited Financial Statements
The proposed audit rule would require a fund's audited financial
statements to be distributed to current investors ``promptly'' after
the completion of the audit.\127\ The audited financial statements
would consist of the applicable financial statements (including any
required reconciliation to U.S. GAAP, including supplementary U.S. GAAP
disclosures), related schedules, accompanying footnotes, and the audit
report. We considered but are not proposing to require the audited
financials to be distributed within 120 days of a private fund's fiscal
year end, similar to the approach under the custody rule. Based on our
experience administering the custody rule, we believe that a 120-day
time period is generally appropriate to allow the financial statements
of an entity to be audited and to provide investors with timely
information. We also understand, however, that preparing audited
financial statements for some arrangements, such as fund of funds
arrangements, may require reliance on third parties, which could cause
an adviser to fail to meet the 120-day timing requirements for
distributing audited financial statements regardless of actions it
takes to meet the requirements. We also recognize there may be times
when an adviser reasonably believes that a fund's audited financial
statements would be distributed within the required timeframe but fails
to have them distributed in time under certain unforeseeable
circumstances. For example, during the COVID-19 pandemic, some advisers
were unable to deliver audited financial statements in the timeframes
required under the custody rule due to logistical disruptions.
Accordingly, and in light of the fact that there is not an alternative
method by which to satisfy the proposed rule as there is under the
custody rule (i.e., undergo a surprise examination), we would require
the audited financial statements to be distributed ``promptly,'' rather
than pursuant to a specific deadline. This would provide some
flexibility without affecting investor protection.
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\127\ Proposed rule 206(4)-10(d).
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Under the proposed audit rule, the audited financial statements
(including any reconciliation to U.S. GAAP prepared for a foreign
private fund, as applicable) must be sent to all of the private fund's
investors. In circumstances where an investor is itself a pooled
vehicle that is in a control relationship with the adviser or its
related persons, it would be necessary to look through that pool (and
any pools in a control relationship with the adviser or its related
persons, such as in a master-feeder fund structure), in order to send
to investors in those pools.\128\ Without such a requirement, the
audited financial statements would essentially be delivered to the
adviser rather than to the parties the financial statements are
designed to inform. Outside of a control relationship, such as if the
private fund investor is an unaffiliated fund of funds, this same
concern is not present, and it would not be necessary to look through
the structure to make meaningful delivery. It would be sufficient to
distribute the audited financial statements to the adviser to, or other
designated party of, the unaffiliated fund of funds. We believe that
this approach would lead to meaningful delivery of the audited
financial statements to the private fund's investors.
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\128\ See proposed rule 211(h)(1)-1 (defining ``control'' and
``distribute'').
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5. Annual Audit, Liquidation Audit, and Audit Period Lengths
Key to the effectiveness of the audit in protecting investors is
timely and regular administration and distribution. Under the proposed
audit provision, an audit must be obtained at least annually and upon
an entity's liquidation. The liquidation audit would serve as the
annual audit for the fiscal year in which it occurs. Requiring the
audit on an annual basis and at liquidation would help alert investors
within months, rather than years, to any material misstatements
identified in the audit and would raise the likelihood of mitigating
losses or reducing exposure to other investor harms. Similarly, a
liquidation audit would help ensure the appropriate and prompt
accounting of the proceeds of a liquidation so that investors can take
timely steps to protect their rights at a time when they may be
vulnerable to misappropriation by the investment adviser. We believe
that it becomes increasingly difficult to correct a material
misstatement the longer it goes undetected. The proposed annual and
liquidation audit requirements would address these concerns while also
balancing the cost, burden, and utility of requiring frequent audits.
The proposed annual audit requirement is consistent with current
practices of private fund advisers that obtain an audit in order to
comply with the custody rule under the Advisers Act, or to satisfy
investor demand for an audit, and would provide investors with
uniformity in the information they are receiving.\129\ When an investor
receives audited financial statements each year from the same private
fund, the investor can compare statements year-over-year. Additionally,
the investor can analyze and compare audited financial statements
across other private funds and similar investment vehicles each year.
Further, we believe investors expect audited financial statements to
include 12-month periods and rely on this uniform period to review and
analyze financial statements year over year for the same private fund.
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\129\ As discussed above, differences between the two rules are
unrelated to the financial statement audit itself.
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With respect to liquidation, we understand that the amount of time
it takes to complete the liquidation of a private fund may vary. A
number of years might elapse between the decision to liquidate an
entity and the completion of the liquidation process. During this time,
the fund may execute few transactions and the total amount of
investments may represent a fraction of the investments that existed
prior to the start of the liquidation process. We further understand
that a lengthy liquidation period can lead to circumstances where the
cost of an annual audit represents a sizeable portion of the fund's
remaining assets.
[[Page 16915]]
While we considered additional modifications to the audit requirement
for a private fund during liquidation, we are concerned that allowing
for less frequent auditing (e.g., every 18 months or two years) during
an entity's liquidation may expose investors to abuse that could then
go unnoticed for prolonged periods. Furthermore, it is our
understanding that allowing for less frequent auditing during
liquidation--for example, requiring an audit every two years in such
circumstances--may not necessarily result in a meaningful cost
reduction to advisers or investors.
6. Commission Notification
The proposed rule would require an adviser to enter into, or cause
the private fund to enter into, a written agreement with the
independent public accountant performing the audit to notify the
Commission (i) promptly upon issuing an audit report to the private
fund that contains a modified opinion and (ii) within four business
days of resignation or dismissal from, or other termination of, the
engagement, or upon removing itself or being removed from consideration
for being reappointed.\130\ The accountant making such a notification
would be required to provide its contact information and indicate its
reason for sending the notification. The written agreement must require
the independent public accountant to notify the Commission by
electronic means directed to the Division of Examinations. Timely
receipt of this information would enable our staff to evaluate the need
for an examination of the adviser. We expect the Division of
Examinations would establish a dedicated email address to receive these
confidential transmissions and would make the address available on the
Commission's website in an easily retrievable location.
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\130\ Proposed rule 206(4)-10(e).
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As we noted above, there is not a similar obligation under the
custody rule for an accountant to notify the Commission as there is for
a surprise examination, although there is a requirement on Form ADV for
a private fund adviser itself to report to the Commission whether it
received a qualified audit opinion and to provide, and update, its
auditor's identifying information.\131\ However, our experience in
receiving notifications from accountants who perform surprise
examinations under the custody rule has led us to conclude that timely
receipt of this information--from an independent third party--would
more readily enable our staff to identify advisers potentially engaged
in harmful misconduct and who have other compliance issues. This would
bolster the Commission's efforts at preventing fraudulent, deceptive,
and manipulative activity and would aid oversight of private fund
advisers.
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\131\ Form ADV Part 1A, Section 7.B.1, Q.23.
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7. Taking All Reasonable Steps To Cause an Audit
We recognize that some advisers may not have requisite control over
a private fund client to cause its financial statements to undergo an
audit in a manner that would satisfy all five elements (paragraphs (a)
through (e)) of the proposed rule. This could be the case, for
instance, where a sub-adviser is unaffiliated with the fund. Therefore,
we are proposing to require that an adviser take all reasonable steps
to cause its private fund client to undergo an audit that would satisfy
the rule, so long as the adviser does not control the private fund and
is neither controlled by nor under common control with the fund.\132\
What would constitute ``all reasonable steps'' would depend on the
facts and circumstances. For example, a sub-adviser that has no
affiliation to the general partner of a private fund that did not
obtain an audit could document the sub-adviser's efforts by including
(or seeking to include) the requirement in its sub-advisory agreement.
On the contrary, if the adviser is the primary adviser to the fund,
even if it is not the general partner or a related person of the
general partner, it would likely not be reasonable for the fund not to
be audited in accordance with the rule.
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\132\ Proposed rule 206(4)-10(f).
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8. Recordkeeping Provisions Related to the Proposed Audit Rule
Finally, the proposal would amend the Advisers Act books and
records rule to require advisers to keep a copy of any audited
financial statements, along with a record of each addressee and the
corresponding date(s) sent, address(es), and delivery method(s) for
each such addressee.\133\ Additionally, the adviser would be required
to keep a record documenting steps taken by the adviser to cause a
private fund client with which it is not in a control relationship to
undergo a financial statement audit that would comply with the rule.
This aspect of the proposal is designed to facilitate our staff's
ability to assess an adviser's compliance with the proposed audit rule
and to detect risks the proposed audit rule is designed to address. We
believe it would similarly enhance an adviser's compliance efforts as
well.
---------------------------------------------------------------------------
\133\ Proposed rule 204-2(a)(21). See also supra footnote 106
(describing the record retention requirements under the books and
records rule).
---------------------------------------------------------------------------
We request comment on all aspects of the proposed audit rule and
related proposed amendments to the books and records rule, including
the following items:
Would the proposed audit rule provide appropriate
protection for investors? If not, please describe what, if any,
modifications would improve investor protection.
The proposed audit rule bears many similarities to
provisions of the custody rule; however, one notable difference is that
there would be no option to, instead, undergo a surprise examination
and rely on a qualified custodian to deliver quarterly statements. What
would be the impact on advisers to private funds that are not relying
on the custody rule's audit provision? Are private funds undergoing
similar audits of their financial statements for other reasons, or
would this represent a new requirement for them? There also are no
exceptions from the proposed rule, as there are in the custody rule,
such as the exception from the surprise examination requirement for
advisers whose sole basis for being subject to the rule is because they
have authority to deduct their advisory fees. What would be the impact
on advisers to private funds that are relying on this and other
exceptions? Do many private fund advisers rely on the exception for
fee-deduction?
Do commenters agree that the similarities of the audit
requirements for the custody rule and for the proposed rule would ease
the compliance burdens of advisers that would be required to comply
with both? Should the rule provide that compliance with one rule would
satisfy the requirements of the other, given the similarities of the
two rules? Why or why not?
The application of the proposed rule to registered
advisers to private funds seeks to balance our policy goal with the
anticipated costs of the proposed measures. Do commenters agree with
this approach? If not, what would be a more effective way of achieving
our goals?
Should the rule apply to all advisers to private funds,
rather than to just advisers to private funds that are registered or
are required to be registered? Should it apply to exempt reporting
advisers? Why or why not?
Similarly, should it apply in the context of all pooled
investment vehicle clients (e.g., funds that rely on section 3(c)(5) of
the Investment Company Act), rather than just in the context of those
that meet the Advisers Act definition of private fund? Should it apply
more broadly to any advisory account with
[[Page 16916]]
financial statements that can be audited? Why or why not?
Should the rule provide any full or partial exceptions,
such as when an adviser plays no role in valuing the fund's assets,
receives little or no compensation for its services, or receives no
compensation based on the value of the fund's assets? Should the rule
provide exceptions for private funds below a certain asset threshold
(e.g., less than $5 million)? A higher or lower amount? Should the rule
provide exemptions for private funds that have only related person
investors, or that have a limited number of investors, such as 5 or
fewer investors? If yes, please identify which advisers or funds we
should except, from which aspects of the proposed audit rule, and why.
Should the rule apply to a sub-adviser to a private fund?
In situations where a fund has multiple advisers, is it clear that a
single audit of the fund's financial statements may satisfy the
proposed audit rule for all of the advisers subject to the rule?
Should the alternative of ``taking all reasonable steps''
to cause a private fund client to be audited apply in any situation,
rather than just in situations where the adviser is not in a control
relationship with its fund client? Why or why not? Is it sufficiently
clear how an investment adviser can establish that it has ``taken all
reasonable steps'' to cause a private fund client to obtain an audit?
Should the rule require accountants performing the
independent public audits to be registered with the PCAOB, as proposed?
Should the rule limit the pool of accountants to those who are subject
to inspection by the PCAOB, as proposed? If the rule does not include
these requirements, should the rule impose any alternative or
additional requirements on such accountants? If so, describe these
additional requirements and explain why they are necessary or
appropriate.
Do commenters agree that the availability of accountants
to perform services for purposes of the proposed audit rule is
sufficient and that even advisers in foreign jurisdictions (or with
private fund clients in foreign jurisdictions) would not have
significant difficulty in finding a local accountant that is eligible
to perform an audit under the proposed rule? Do advisers have
reasonable access to independent public accountants that are registered
with, and subject to inspection by, the PCAOB in the foreign
jurisdictions in which they operate? If not, how should the rule
address this issue?
Should the rule require advisers to obtain audits
performed under rule 1-02(d) of Regulation S-X, as proposed? If not,
what other auditing standards should the rule allow? Are there certain
non-U.S. auditing standards that the proposed rule should explicitly
include?
Should the rule require private funds to prepare audited
financial statements in accordance with generally accepted accounting
principles, as proposed? Should the rule include any additional
requirements regarding the preparation of financial statements? If so,
what requirements, and why?
As proposed, should financial statements prepared in
accordance with accounting standards other than U.S. GAAP for foreign
private funds meet the requirements of the rule provided they contain
information substantially similar to statements prepared in accordance
with U.S. GAAP, material differences with U.S. GAAP are reconciled, and
the reconciliation is distributed to investors along with the financial
statements? If so, should we specify what ``substantially similar''
means?
Would there be unique challenges to complying with the
rule for auditors and advisers to private funds in foreign
jurisdictions? For example, might certain advisers or auditors face
challenges in complying with the proposed rule's Commission
notification requirement, including because of applicable privacy and
other local laws? If so, what would alleviate these challenges and
still achieve the policy goals of the proposed audit rule?
Do commenters agree that the proposed rule's requirement
to distribute the audited financial statements promptly would provide
appropriate flexibility regarding the timing of the distribution of
audited financial statements? Should there nevertheless be an outer
limit on the number of days an investment adviser has from its fiscal
year end for the distribution of audited financial statements? If so,
what should that limit be? Would it be more appropriate for
distribution to be required within 120 days of the end of the fund's
fiscal year, as under the custody rule? Alternatively, would a longer
or shorter period be appropriate in most circumstances? Should the
timeline for distributing audited financial statements align with the
timeline for distributing quarterly statements under the proposed
quarterly statement rule? Why or why not? We understand that funds of
funds or certain funds in master-feeder structures (including those
advised by related persons) have difficulty satisfying the 120-day
requirement and that our staff has indicated they would not recommend
enforcement if certain of these funds satisfy the distribution
requirement within 180 or 260 days of the fund's fiscal year end,
depending on a variety of circumstances.\134\ If the rule contained a
specific distribution deadline, would these types of funds need a
separate deadline or other special treatment?
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\134\ See generally Staff Responses to Questions About the
Custody Rule, available at https://www.sec.gov/divisions/investment/custody_faq_030510.htm.
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Instead of requiring prompt distribution of the audited
financial statement to investors, should we require the statement to be
distributed or made available to investors upon request?
Should the rule provide additional flexibility, such as
for situations in which the adviser can demonstrate that it reasonably
believed that it would be able to comply with the rule but failed due
to certain unforeseeable circumstances?
Should the rule require annual audits, as proposed? Should
the rule require an audit upon a private fund's liquidation, as
proposed? Should we modify either or both of these requirements? If so,
how should we modify these requirements, and why?
Advisers would be required to comply with the proposed
audit rule beginning with their first fiscal year after the compliance
date and any liquidation that occurs after the compliance date.
Advisers would also be required to obtain an audit annually. We
understand that newly formed and liquidating funds may face unique
challenges. For instance, the value provided by an audit of a very
short period of time, such as a period of less than three-months (a
``stub period''), may be diminished because there is a lack of
comparability in the information provided. In addition, we understand
that the cost of obtaining an audit covering a few months can be
similar to the cost of an audit covering an entire fiscal year. We
further understand that when newly formed entities have few financial
transactions and/or investments, obtaining an audit, relative to the
investor protections ultimately offered by obtaining the audit, may be
burdensome. Should the rule allow newly formed or liquidating entities
to obtain an audit less frequently than annually to avoid stub period
audits? Should the rule permit advisers to satisfy the audit
requirement by relying on an audit on an interval other than annually
when a fund is liquidating? For example, should we allow advisers
[[Page 16917]]
to rely on an audit of a fund every two years during the liquidation
process?
If the rule were to permit audits less frequently than on
an annual basis, should it also include additional restrictions or
requirements? If so, what restrictions or requirements, and why? For
instance, should it require investment advisers to create and
distribute alternative financial reporting for the fund to investors
(e.g., cash-flow audit or asset verification)? Alternatively, or in
addition to alternative financial reporting, should the rule require
advisers to obtain a third-party examination? If so, what should the
examination consist of, and why? For example, would allowing advisers
to obtain an audit less frequently than annually during a liquidation
raise investor protection concerns that additional requirements could
address given the potential for a liquidation to last for an extended
period? If so, what additional requirements, and why? For example,
should advisers be required to provide notice to investors of their
intent to liquidate an entity in these circumstances? Should advisers
be required to obtain investor consent prior to satisfying the audit
requirement by relying on audits on a less than annual basis? Should we
set an outer limit for the period such an audit could cover (e.g., 15
months)?
Should the rule define ``liquidation'' for purposes of the
liquidation audit requirement? If so, how? For example, should we base
such a definition on a certain percentage of assets under management of
the entity from or over previous fiscal period(s) or a stated threshold
based on an absolute dollar amount of the entity's assets under
management? Should we base the definition on a calculation of the ratio
of the management fees assessed on assets under management of the
entity or some other basis, for example, to detect whether an adviser
is charging management fees on a very small amount of assets?
Are there risks posed to investors when an entity is
liquidating that the proposed rule does not address? If so, please
describe those risks. How should we modify the rule to address such
risks?
Are there some types of investments that pose a greater
risk of misappropriation or loss to investors during a liquidation that
the rule should specifically address to provide greater investor
protection? If so, please describe the investment type; the particular
risk the investment type poses to investors during liquidation; and how
to modify the proposed rule to address such investor risk.
We are not proposing the filing of a copy of the audit
report or a copy of the audited financial statements with the
Commission; should the rule contain such a requirement? Why or why not?
Would the requirement for an accountant to comply with the
notification requirement change the approach that an accountant would
take with respect to audits that normally are performed for purposes of
satisfying the custody rule? If so, how?
Should we, as proposed, require advisers to enter into, or
cause a private fund to enter into, a written agreement with the
independent public accountant completing the audit to notify the
Commission in connection with a modified opinion or termination?
Do commenters agree that the professional engagement
period of an audit performed under the rule should begin and end as
indicated in Regulation S-X rule 2-01(f)(5), as proposed? If not, why
not?
As noted above, the proposed Commission notification
provision bears some similarities to, and is drawn from our experience
with, a similar custody rule requirement in the surprise examination
context with which we believe advisers may likely already have some
familiarity. The regulations in 17 CFR 240.17a-5 (rule 17a-5) require a
broker or dealer's self-report to the Commission within one business
day and to provide a copy to the accountant. The accountant must report
to the Commission about any aspects of the broker or dealer's report
with which the accountant does not agree. If the broker or dealer fails
to self-report, the accountant must report to the Commission to
describe any material weaknesses or any instances of non-compliance
that triggered the notification requirement. Should the audit rule
contain similar requirements? Why or why not? Are private fund advisers
and the accountants that perform private fund financial statement
audits more familiar with Rule 17a-5's notification requirement than
the custody rule's notification requirement?
Do commenters agree that the related proposed amendments
to the books and records rule would facilitate compliance with the
proposed audit rule? What additional or alternative amendments should
the rule include, if any?
C. Adviser-Led Secondaries
We propose to require an adviser to obtain a fairness opinion in
connection with certain adviser-led secondary transactions where an
adviser offers fund investors the option to sell their interests in the
private fund, or to exchange them for new interests in another vehicle
advised by the adviser. This would provide an important check against
an adviser's conflicts of interest in structuring and leading a
transaction from which it may stand to profit at the expense of private
fund investors. The proposed adviser-led secondaries rule would
prohibit an adviser from completing an adviser-led secondary
transaction with respect to any private fund, unless the adviser
distributes to investors in the private fund, prior to the closing of
the transaction, a fairness opinion from an independent opinion
provider and a summary of any material business relationships the
adviser or any of its related persons has, or has had within the past
two years, with the independent opinion provider.\135\
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\135\ Proposed rule 211(h)(2)-2. The proposed rule would not
apply to advisers that are not required to register as investment
advisers with the Commission, such as state-registered advisers and
exempt reporting advisers.
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Investments in closed-end private funds are typically illiquid and
require a long-term investor commitment of capital. Such funds
generally do not permit investors to withdraw or redeem their fund
interests prior to the end of the term. Open-end private funds may also
limit or restrict an investor's ability to withdraw or redeem its
interest, for example, with side pockets or illiquid sleeves. Without
the ability to cash out all or a portion of their interest from the
fund, investors have historically sought liquidity by selling their
interests on the secondary market to third parties. Advisers typically
have a relatively minor role in such ``investor-led'' transactions, as
investors engage in the transaction directly with the prospective
purchaser.
In recent years, advisers have become increasingly active in the
secondary market. The number of ``adviser-led'' transactions has
increased, with the deal value of such transactions representing a
meaningful portion of the secondary market, particularly for closed-end
private funds.\136\ Adviser-led transactions are similar to investor-
led transactions in that they typically provide a mechanism for
investors to obtain liquidity; however, they also
[[Page 16918]]
have the potential to provide additional benefits to advisers and
investors. For example, an adviser-led transaction may seek to secure
additional capital and/or time to maximize the value of fund assets. An
adviser may accomplish this by permitting investors to ``roll'' their
interests into a new vehicle that has a longer term and/or additional
capital to invest.\137\
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\136\ See, e.g., Private Equity International, GP-Led
Secondaries Report (Feb. 28, 2021), available at https://www.privateequityinternational.com/gp-led-secondaries-report-2021/
(noting one industry participant estimated that adviser-led
secondary transactions accounted for $26 billion (or 44% of the
secondary market) in 2020, while another estimated that they
accounted for more than $30 billion (or more than 50% of the
secondary market)).
\137\ An investor would typically obtain liquidity in the event
it elects to sell--rather than roll--its fund interest.
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Adviser-led secondaries often are highly bespoke transactions that
can take many forms. For purposes of the rule, we propose to define
them as transactions initiated by the investment adviser or any of its
related persons that offer the private fund's investors the choice to:
(i) Sell all or a portion of their interests in the private fund; or
(ii) convert or exchange all or a portion of their interests in the
private fund for interests in another vehicle advised by the adviser or
any of its related persons.\138\ We generally would consider a
transaction to be initiated by the adviser if the adviser commences a
process, or causes one or more other persons to commence a process,
that is designed to offer private fund investors the option to obtain
liquidity for their private fund interests. However, whether the
adviser or its related person initiates a secondary transaction
requires a facts and circumstances analysis. We would generally not
view a transaction as initiated by the adviser if the adviser, at the
unsolicited request of the investor, assists in the secondary sale of
such investor's fund interest.
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\138\ Proposed rule 211(h)(1)-1.
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This definition generally would include secondary transactions
where a fund is selling one or more assets to another vehicle managed
by the adviser, if investors have the option either to obtain liquidity
or to roll all or a portion of their interests into the other vehicle.
Examples of such transactions may include single asset transactions
(such as the fund selling a single asset to a new vehicle managed by
the adviser), strip sale transactions (such as the fund selling a
portion of multiple assets to a new vehicle managed by the adviser),
and full fund restructurings (such as the fund selling all of its
assets to a new vehicle managed by the adviser). The proposed
definition also would capture secondary transactions that may not
involve a cross sale between two vehicles managed by the same
adviser.\139\ For example, an adviser may arrange for one or more new
investors to purchase fund interests directly from the existing
investors as part of a ``tender offer'' or similar transaction.
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\139\ We would not consider the proposed rule to apply to cross
sales where the adviser does not offer the private fund's investors
the choice to sell, convert, or exchange their fund interest.
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While adviser-led transactions can provide liquidity for investors
and secure additional time and capital to maximize the value of fund
assets, they also raise certain conflicts of interest. The adviser and
its related persons typically are involved on both sides of the
transaction and have interests in the transaction that are different
than, or in addition to, the interests of the private fund investors.
For example, because the adviser may have the opportunity to earn
economic and other benefits conditioned upon the closing of the
secondary transaction, such as additional management fees or carried
interest, the adviser generally has a conflict of interest in setting
and negotiating the transaction terms.
Ensuring that the private fund and the investors that participate
in the secondary transaction are offered a fair price is a critical
component of preventing the type of harm that might result from the
adviser's conflict of interest in leading the transaction.\140\
Accordingly, prior to the closing of the transaction, the proposed rule
would require advisers to obtain a written opinion stating that the
price being offered to the private fund for any assets being sold as
part of an adviser-led secondary transaction is fair.\141\ This process
would provide an important market check for private fund investors by
providing some assurance that the price being offered is based on an
underlying valuation that falls within a range of reasonableness. We
understand that certain advisers obtain fairness opinions as a matter
of best practice because investors often lack access to sufficient
information, or may not have the capabilities or resources, to conduct
their own analysis of the price. However, to the extent that this
practice is not universal, the proposed rule would mandate it in
connection with all adviser-led secondary transactions.
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\140\ As a fiduciary, the adviser is obligated to act in the
fund's best interest and to make full and fair disclosure to the
fund of all conflicts and material facts associated with the
adviser-led transaction. See, e.g., Commission Interpretation
Regarding Standard of Conduct for Investment Advisers, Investment
Advisers Act Release No. 5248 (June 5, 2019) [84 FR 33669 (July 12,
2019)], at 24-25 (``2019 IA Fiduciary Duty Interpretation''). See
also EXAMS Private Funds Risk Alert 2020, supra footnote 9.
\141\ Proposed rule 211(h)(1)-1 (defining ``fairness opinion'').
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To mitigate the potential influence of the adviser's conflict of
interest further, the rule would require these opinions to be issued
only by an ``independent opinion provider,'' which is one that (i)
provides fairness opinions in the ordinary course of its business and
(ii) is not a related person of the adviser.\142\ The ordinary course
of business requirement would largely correspond to persons with the
expertise to value illiquid and esoteric assets based on relevant
criteria. The requirement that the opinion provider not be a related
person of the adviser would reduce the risk that certain affiliations
could result in a biased opinion.\143\
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\142\ Proposed rule 211(h)(1)-1.
\143\ See supra section II.A for a discussion of the definition
of ``related person.''
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We recognize, however, that other business relationships may have
the potential to result, or appear to result, in a biased opinion,
particularly if such relationships are not disclosed to private fund
investors. For example, an opinion provider that receives an income
stream from an adviser for performing services unrelated to the
issuance of the opinion might not want to jeopardize its business
relationship with the adviser by alerting the private fund investors
that the price being offered is unfair (or by otherwise refusing to
issue the fairness opinion). By requiring disclosure of such material
relationships, the proposed rule would put private fund investors in a
position to evaluate whether any conflicts associated with such
relationships may cause the opinion provider to deliver a biased
opinion. Thus, the proposed rule would require the adviser to prepare
and distribute to private fund investors a summary of any material
business relationships the adviser or any of its related persons has,
or has had within the past two years, with the independent opinion
provider. Whether a business relationship would be material under the
proposed rule would require a facts and circumstances analysis;
however, for purposes of the proposed rule, we believe that audit,
consulting, capital raising, investment banking, and other similar
services would typically meet this standard.
The proposed rule would require an adviser to distribute the
opinion and the material business relationship summary to
investors.\144\ We believe that this proposed requirement would ensure
that investors receive the benefit of an independent price assessment,
which we believe will improve their decision-making ability and their
overall confidence in the transaction.
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\144\ Proposed rule 211(h)(2)-2.
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We request comment on all aspects of the proposed rule, including
the following items:
[[Page 16919]]
Do commenters agree that adviser-led secondary
transactions can be of some benefit to a private fund and its
investors?
Do commenters agree with the scope of the proposed rule?
Should the rule apply to all investment advisers? Why or why not? What
are the factors that weigh in favor of expanding the scope of the
proposed rule to apply to a broader scope of advisers than proposed?
Are there particular types of advisers that should or should not be
subject to the rule? Should the rule only apply when the adviser or its
related person is general partner (or equivalent) of a fund that is
party to the transaction?
Should certain adviser-led transactions be exempt from the
proposed rule? For example, if the adviser conducts a competitive sale
process for the assets being sold, which ultimately leads to the price,
should advisers still be required to obtain a fairness opinion? Do
competitive bids typically represent net asset value? Do prospective
purchasers typically bid at a discount to net asset value? Does net
asset value always correspond to the current value of the assets being
sold? Why or why not? Are there other price discovery processes that we
should require to protect investors?
Should certain adviser-led transactions be exempt from the
rule, such as adviser-led transactions involving liquid funds? For
example, if the underlying assets being sold in the transaction are
predominantly publicly traded securities, should advisers still be
required to obtain a fairness opinion? Do such transactions present the
same concerns as adviser-led secondary transactions involving illiquid
funds where the underlying assets are typically illiquid and not listed
or quoted on a securities exchange? Are there other hedge fund
transactions that we should exempt from the rule, such as hedge fund
restructurings where an adviser may be merging the portfolios of two
different hedge funds and gives all affected investors the option to
redeem or convert/exchange their interests into the new fund? Should
the exemption depend on whether the price of the transaction is based
on net asset value? Why or why not?
Are there other transactions for which we should require
private fund advisers to obtain a fairness opinion? For example, should
we require advisers to obtain a fairness opinion before certain cross
transactions between private funds it manages? If so, which
transactions? Should we provide certain cross transaction exemptions,
such as exemptions for bridge financings or syndications where the
selling fund transfers the investments within a short period at a price
equal to cost plus interest?
Should the scope of the fairness opinion be limited to the
price, as proposed? Alternatively, should we require the fairness
opinion to cover all, or certain other, terms of the transaction? For
example, should we revise the definition of ``fairness opinion'' to a
written opinion stating that the terms of the adviser-led secondary
transaction are fair to the private fund? Why or why not?
Should the rule give investment advisers the option to
obtain either a fairness opinion or a third-party valuation? Why or why
not? What are the advantages and disadvantages of a third-party
valuation as compared to a fairness opinion, and vice versa?
We request comment on the proposed use of ``related
person.'' Do commenters agree that the fairness opinion should be
issued by a person that is not a related person of the adviser? Should
we adopt a different definition of ``related person'' than the one
proposed?
The proposed rule would require an ``independent opinion
provider'' to provide fairness opinions ``in the ordinary course of its
business.'' Do commenters agree with this approach?
Instead of requiring disclosure of any material business
relationships between the adviser (or its related persons) and the
independent opinion provider, should the rule prohibit firms with
certain business relationships with the adviser, its related persons,
or the private fund from providing the fairness opinion? For example,
if a firm has provided consulting, prime broker, audit, capital
raising, or investment banking services to the private fund or the
adviser or its related persons within a certain time period--such as
two or three years--should the rule prohibit the firm from providing
the opinion? If so, should the rule include a threshold of materiality,
regularity, or frequency for some or all of such services to trigger
such a prohibition?
Should we require the independent opinion provider to have
any specific qualifications, licenses, or registrations?
Should we define the term ``transaction'' in the
definition of ``adviser-led secondary transaction''? If so, how should
the rule define ``transaction''? Should we reference the various types
of adviser-led secondary transactions in the definition? For example,
should ``transaction'' include only single asset transactions, strip
sale transactions, and other similar secondary transactions? Should we
include in the definition of ``adviser-led secondary transaction''
transactions initiated by the adviser's related persons?
Should we define, or provide additional guidance
regarding, the phrase ``initiated by the investment adviser or any of
its related persons''? Should we define, or provide additional guidance
regarding, the role the adviser would have to play in a secondary
transaction for it to be considered an adviser-led transaction subject
to the proposed rule?
Should the rule require the fairness opinion to state that
the private fund and/or its investors may rely on the opinion? Why or
why not?
Should we require the fairness opinion to be obtained on
behalf of the private fund as proposed? Alternatively, should we
require the fairness opinion to be obtained on behalf of the private
fund investors? Are there characteristics of certain types of adviser-
led transactions, such as tender offers, that would require the
fairness opinion to be obtained on behalf of the private fund investors
rather than the private fund?
Should the adviser be required to distribute a summary of
any material business relationships the adviser or its related persons
has, or has had within the past two years, with the independent opinion
provider as proposed? Should we provide guidance or impose requirements
regarding the level of detail advisers should include in the summary?
For example, should we require advisers to disclose the total amount
paid to the independent opinion provider by the adviser or its related
persons, if applicable? Why or why not? Is two years the appropriate
look-back period? Are there any other conflict disclosures we should
require in the fairness opinion or otherwise require to be made
available to investors?
Should we define ``material business relationship'' for
purposes of the proposed rule? Should the rule include a threshold of
regularity or frequency (in addition to or in lieu of the materiality
threshold) for some or all of such relationships or services to trigger
a disclosure requirement?
Should we require advisers to distribute the fairness
opinion to investors as proposed? Alternatively, should we require
advisers to only distribute or make the fairness opinion available to
investors upon request?
We recognize that certain adviser-led transactions may not
involve investors rolling their interests into a new vehicle managed by
the adviser. For example, an adviser may arrange for a new investor to
offer to purchase fund interests directly from existing
[[Page 16920]]
investors, such as a tender offer. Do commenters agree that the first
prong of the definition would cover such transactions? Should the rule
treat such transactions differently?
Should the rule apply to adviser-led transactions
initiated by the adviser or its related persons as proposed? Is the
definition of ``related person'' too broad in this context such that it
would capture secondary transactions initiated by third parties
unrelated to the adviser? Should we revise the definition of ``related
person'' to include an investment discretion requirement? Similarly, is
the definition of ``control'' too broad in this context?
We recognize that, for certain adviser-led transactions,
the closing of the underlying deal may not occur simultaneously with
the closing of the new vehicle managed by the adviser. How should the
rule take this into account, if at all? For example, should we clarify
that, for purposes of the rule, an adviser would not be deemed to have
completed an adviser-led secondary transaction until the underlying
deal has closed (if applicable)? Alternatively, should we prohibit an
adviser from calling investor capital prior to obtaining and
distributing the fairness opinion?
1. Recordkeeping for Adviser-Led Secondaries
We propose amending rule 204-2 under the Advisers Act to require
advisers to retain books and records to support their compliance with
the proposed adviser-led secondaries rule, which would help facilitate
the Commission's inspection and enforcement capabilities. We propose to
require advisers to retain a copy of the fairness opinion and material
business relationship summary distributed to investors, as well as a
record of each addressee, the date(s) the opinion was sent,
address(es), and delivery method(s).\145\ These proposed requirements
would facilitate our staff's ability to assess an adviser's compliance
with the proposed rule and would similarly enhance an adviser's
compliance efforts.
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\145\ See supra footnote 106 (describing the record retention
requirements under the books and records rule).
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We request comment on this aspect of the proposed rule:
Should we require advisers to maintain the proposed
records or would these requirements be overly burdensome for advisers?
Are there alternative or additional recordkeeping requirements we
should impose?
Should we require advisers to retain a record of each
addressee, the date(s) the statement was sent, address(es), and
delivery method(s) as proposed? Why or why not?
D. Prohibited Activities
We are also proposing to prohibit a private fund adviser from
engaging in certain sales practices, conflicts of interest, and
compensation schemes that are contrary to the public interest and the
protection of investors. We have observed certain industry practices
over the past decade that have persisted despite our enforcement
actions and that disclosure alone will not adequately address.\146\ As
discussed below, we believe that these sales practices, conflicts of
interest, and compensation schemes must be prohibited in order to
prevent certain activities that could result in fraud and investor
harm.\147\ We believe these activities incentivize advisers to place
their interests ahead of their clients' (and, by extension, their
investors'), and can result in private funds and their investors,
particularly smaller investors that are not able to negotiate
preferential deals with the adviser and its related persons, bearing an
unfair proportion of fees and expenses. The proposed rule would
prohibit these activities regardless of whether the private fund's
governing documents permit such activities or the adviser otherwise
discloses the practices and regardless of whether the private fund
investors (or governance mechanisms acting on their behalf, such as
limited partner advisory committees) have consented to the activities
either expressly or implicitly. Also, the proposed rule would prohibit
these activities even if they are performed indirectly, for example by
an adviser's related persons, because the activities have an equal
potential to harm the fund and its investors regardless of whether the
adviser engages in the activity directly or indirectly.\148\ As noted
above, we believe these prohibitions are necessary given the lack of
governance mechanisms that would help check overreaching by private
fund advisers.
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\146\ See High-End Bargaining Problems, Vanderbilt Law Review
(forthcoming), Professor William Clayton (Jan. 8, 2022) at 9
(challenging ``the idea that sophisticated parties will demand
appropriate levels of disclosure and appropriate processes without
any intervention by policymakers . . .'').
\147\ See sections 206 and 211(h)(2) of the Act.
\148\ Any attempt to avoid any of the proposed rules'
restrictions, depending on the facts and circumstances, would
violate section 208(d) of the Act's general prohibitions against
doing anything indirectly which would be prohibited if done
directly. Section 208(d) of the Advisers Act.
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Proposed rule 211(h)(2)-1 would prohibit an investment adviser to a
private fund, directly or indirectly, from engaging in certain
activities with respect to the private fund or any investor in that
private fund, including:
(i) Charging certain fees and expenses to a private fund or
portfolio investment, including accelerated monitoring fees; fees or
expenses associated with an examination or investigation of the adviser
or its related persons by governmental or regulatory authorities;
regulatory or compliance expenses or fees of the adviser or its related
persons; or fees and expenses related to a portfolio investment on a
non-pro rata basis when multiple private funds and other clients
advised by the adviser or its related persons have invested (or propose
to invest) in the same portfolio investment;
(ii) Reducing the amount of any adviser clawback by the amount of
certain taxes;
(iii) Seeking reimbursement, indemnification, exculpation, or
limitation of its liability by the private fund or its investors for a
breach of fiduciary duty, willful misfeasance, bad faith, negligence,
or recklessness in providing services to the private fund; and
(iv) Borrowing money, securities, or other fund assets, or
receiving an extension of credit, from a private fund client.
This proposed rule would apply to all advisers to private funds,
regardless of whether they are registered with the Commission or one or
more states, exempt reporting advisers, or prohibited from
registration. We believe that this scope is appropriate since we
believe these activities are contrary to the public interest and the
protection of investors and have the potential to lead to fraud. We are
proposing this rule under sections 206 and 211 of the Advisers Act,
which sections apply to all investment advisers, regardless of SEC-
registration status.
We request comment on the scope of the proposed rule, including the
following items:
Should the rule apply to all advisers as proposed?
Alternatively, should the rule apply only to SEC-registered advisers?
If so, why?
Should the rule only prohibit these activities with
respect to an adviser's private fund clients and the investors in those
private funds? Should the rule apply more broadly or more narrowly? For
example, should the rule apply to such activities with respect to all
clients of an adviser? Should the rule apply to such activities with
respect to persons to which the adviser offers co-
[[Page 16921]]
investment opportunities even if the adviser does not classify them as
its clients?
We have historically taken the position that most of the
substantive provisions of the Advisers Act do not apply with respect to
the non-U.S. clients (including funds) of a registered offshore
adviser.\149\ In taking this approach, the Commission noted that U.S.
investors in an offshore fund generally would not expect the full
protection of the U.S. securities laws and that U.S. investors may be
precluded from an opportunity to invest in an offshore fund if their
participation would result in full application of the Advisers Act and
rules thereunder.\150\ Similarly, the proposed prohibited activities
rule would not apply to a registered offshore adviser's private funds
organized outside of the United States, regardless of whether the
private funds have U.S. investors. Do commenters agree that registered
offshore advisers should not be subject to this rule with respect to
their offshore private fund clients or offshore investors? Should other
rules in this rulemaking package take the same approach, or a different
approach, with respect to a registered offshore adviser's offshore
private fund clients? Please explain.
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\149\ See, e.g., Exemptions for Advisers to Venture Capital
Funds, Private Fund Advisers With Less Than $150 Million in Assets
Under Management, and Foreign Private Advisers, Investment Advisers
Act Release No. 3222 (June 22, 2011) [76 FR 39645 (July 6, 2011)];
Marketing Release, supra footnote 61, at n.199.
\150\ See Registration Under the Advisers Act of Certain Hedge
Fund Advisers, Investment Advisers Act Release No. 2333 (Dec. 2,
2004) [69 FR 72054, 72072 (Dec. 10, 2004)].
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Instead of prohibiting these activities, should the rule
prohibit these activities unless the adviser satisfies certain
governance and other conditions (e.g., disclosure to investors in all
relevant funds/vehicles, approval by the limited partner advisory
committee (or other similar body) or directors)? Should the rule
prohibit these activities unless the adviser obtains approval for them
by a majority (by number and/or in interest) of investors? Should the
rule permit non pro-rata fee and expense allocations if such practice
is disclosed to, and consented by, co-investors?
Should we amend the books and records rule to require
advisers to retain specific documentation evidencing compliance with
the prohibited activities rule? For example, records showing how fees
and expenses associated with an examination or investigation of the
adviser or its related persons by governmental or regulatory
authorities were paid or showing the allocations of fees and expenses
related to a portfolio investment on an investment by investment basis?
Would advisers be able to obtain or generate sufficient records to
demonstrate compliance with all aspects of the proposed rule? Should we
amend the books and records rule to require advisers to prepare a
memorandum on an annual basis attesting to their compliance with each
aspect of the proposed rule?
1. Fees for Unperformed Services
First, the prohibited activities rule would prohibit an investment
adviser from charging a portfolio investment for monitoring, servicing,
consulting, or other fees in respect of any services the investment
adviser does not, or does not reasonably expect to, provide to the
portfolio investment.\151\ These payments sometimes are referred to as
``accelerated payments.''
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\151\ Proposed rule 211(h)(2)-1(a)(1).
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An adviser typically receives management fees and performance-based
compensation for providing advisory services to a fund. A fund's
portfolio investments may also make payments to the adviser and its
related persons. For example, some private fund advisers enter into
arrangements with a fund's portfolio investments to provide management,
consulting, financial, servicing, advisory, or other services. The
adviser and the applicable portfolio investment would enter into a
monitoring agreement or a management services agreement documenting the
payment terms and the services the adviser will provide.\152\ Such
agreements often include acceleration clauses, which permit the adviser
to accelerate the unpaid portion of the fee upon the occurrence of
certain triggering events, even though the adviser will never provide
the contracted for services.\153\ The accelerated payments reduce the
value of the portfolio investment upon the private fund's exit and thus
reduce returns to investors.
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\152\ Monitoring fees frequently are based on a percentage of
EBITDA (earnings before income, taxes, depreciation, and
amortization). The agreements often renew automatically and
typically include periodic fee increases.
\153\ Common triggering events include initial public offerings,
dispositions, and change of control events.
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Because the private fund (and, by extension, its investors)
typically bears the costs of such payments indirectly and the adviser
typically receives the benefit, the receipt of such fees gives rise to
conflicts of interest between the fund (and, by extension, its
investors), on the one hand, and the adviser, on the other hand. For
example, the adviser receives the benefit of the accelerated fees
without incurring any costs associated with having to provide any
services. The private fund, however, may have a lower return on its
investment because the accelerated monitoring fees may reduce the
portfolio investment's available cash, in turn reducing the
investment's value in advance of a public offering or sale transaction.
An adviser also may have an incentive to cause the fund to exit a
portfolio investment earlier than anticipated, which may result in the
fund receiving a lesser return on its investment.\154\ Further, the
potential for the adviser to receive these economic benefits creates an
incentive for the adviser to seek portfolio investments for its own
benefit rather than for the fund's. We believe prohibiting this
practice, which distorts the economic relationship between the private
fund and the adviser, would help prevent the adviser from placing its
own interests ahead of the private fund.
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\154\ Such incentive may be mitigated, in certain circumstances,
to the extent the adviser's performance-based compensation would
also be reduced in whole or part by the receipt of these payments.
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In addition to these conflicts, we believe that charging a
portfolio investment for unperformed services creates a compensation
scheme that is contrary to the public interest and the protection of
investors because such practice unjustly enriches the adviser at the
expense of the private fund and its underlying investors who are not
receiving the benefit of any services. Accordingly, the proposed rule
would prohibit an adviser from charging these types of accelerated
payments.
The prohibited activities rule would not prohibit an adviser from
receiving payment for services actually provided. The proposed rule
also would not prohibit an adviser from receiving payments in advance
for services that it reasonably expects to provide to the portfolio
investment in the future. For example, if an adviser expects to provide
monitoring services to a portfolio investment, the proposed rule would
not prohibit the adviser from charging for those services.\155\ Rather,
the proposed rule would prohibit compensation schemes where an
[[Page 16922]]
adviser charges for services that it does not reasonably expect to
provide.
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\155\ To the extent the adviser ultimately does not provide the
services, however, the proposed rule would require the adviser to
refund any prepaid amounts attributable to the unperformed services.
See proposed rule 211(h)(2)-1(a)(1) (prohibiting an adviser from
charging a portfolio investment for fees in respect of any services
that the investment adviser does not provide to the portfolio
investment).
---------------------------------------------------------------------------
We also do not intend to prohibit an arrangement where the adviser
shifts 100% of the economic benefit of any portfolio investment fee to
the private fund investors, whether through an offset, rebate, or
otherwise. We recognize that certain advisers offset management fees or
other amounts payable to the adviser at the fund level by the amount of
portfolio investment fees paid to the adviser. However, private funds
with a 100% management fee offset would not comply with the proposed
rule if there are excess fees retained by the adviser where no further
management fee offset can be applied and the private fund investors are
not offered a rebate or another economic benefit equal to their pro
rata share of any such excess fees.
We request comment on this aspect of the prohibited activities
rule, including the following items:
Are there any scenarios in which we should permit an
adviser to charge a fund's portfolio investment for unperformed
services? If so, please explain.
Should we prohibit an adviser from being paid in advance
for services it reasonably expects to provide in the future? Why or why
not?
As noted above, if an adviser is paid in advance, and
reasonably expects to perform services, but ultimately does not provide
the contracted for services, the proposed rule would require the
adviser to refund the prepaid amount attributable to the unperformed
services. Do commenters agree with this approach? Why or why not?
The proposed rule specifically references ``monitoring,
servicing, consulting, or other fees.'' Do commenters agree with this
list? Should we eliminate any? Are there additional or alternative
types of remuneration that the rule should reference?
Do commenters agree that if an adviser shifts 100% of the
economic benefit of any portfolio investment fee to the private fund
investors, whether through an offset, rebate, or otherwise, the adviser
would not violate the proposed rule? Why or why not? We recognize that
certain tax-sensitive investors often waive the right to receive their
share of any rebates of portfolio investment fees. How should the rule
take into account such waivers, if it all? For example, to the extent
one investor does not accept its share, should the rule require the
adviser to distribute such amount to the other investors in the fund?
Why or why not?
Should the rule instead permit an adviser to engage in
this activity if the adviser satisfies certain disclosure, governance,
and/or other conditions (e.g., disclosure to investors in all relevant
funds/vehicles, approval by the LPAC (or other similar body) or
directors)?
The proposed rule would prohibit compensation schemes
where an adviser charges for services that it does not reasonably
expect to provide. Is ``reasonably expect'' the appropriate standard?
Should we provide examples or guidance to assist advisers in complying
with this standard? Does this standard have the potential to reduce the
effectiveness of the rule? Are there other standards we should adopt?
2. Certain Fees and Expenses
The second and third elements of the prohibited activities rule
would prevent an adviser from charging a private fund for fees or
expenses associated with an examination or investigation of the adviser
or its related persons by any governmental or regulatory authority, as
well as regulatory and compliance fees and expenses of the adviser or
its related persons.\156\
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\156\ Proposed rules 211(h)(2)-1(a)(2) and (3). This prohibition
would include fees and expenses related to an examination or
investigation of the adviser by the Commission, including the amount
of any settlements or fines paid in connection therewith.
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Advisers incur various fees and expenses in connection with the
establishment and ongoing operations of their advisory business.
Establishment fees and expenses often relate to the structuring and
organization of the adviser's business, including the adviser's
registration with financial regulators, such as the Commission. Ongoing
fees and expenses often relate to the adviser's overhead and
administrative expenses, such as salary, rent, and office supplies.
Ongoing expenses also may include those associated with an examination
or investigation of the adviser or its related persons.
The proposed rule would prohibit an adviser from charging a private
fund for (i) fees and expenses associated with an examination or
investigation of the adviser or its related persons by any governmental
or regulatory authority, and (ii) regulatory or compliance fees and
expenses of the adviser or its related persons, even where such fees
and expenses are otherwise disclosed. We have seen an increase in
private fund advisers charging these expenses to private fund clients.
These types of expenses, which are a cost of being an investment
adviser, should not be passed on to private fund investors, whether as
a separate expense (in addition to a management fee) or as part of a
pass-through expense model.\157\ For example, we believe advisers
should bear the compliance expenses related to their registration with
the Commission, including fees and expenses related to preparing and
filing all items and corresponding schedules in Form ADV. Similarly, we
believe that an adviser should bear any expenses related to state
licensing and registration requirements applicable to the adviser and
its related persons, including expenses related to registration and
licensure of advisory personnel who contact or solicit investments from
state pension or similar plans.
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\157\ Certain private fund advisers utilize a pass-through
expense model where the private fund pays for most, if not all,
expenses, including the adviser's expenses, but the adviser does not
charge a management, advisory, or similar fee. We recognize that
this aspect of the proposed rule would likely require advisers that
pass on the types of fees and expenses we propose to prohibit to re-
structure their fee and expense model.
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We believe allocating these types of expenses to a private fund
client is contrary to the public interest and is harmful to investors
because they create an incentive for an adviser to place its own
interests ahead of the private fund's interests and unfairly allocate
expenses to the fund, even where fully disclosed. For example, in some
circumstances, an adviser may charge a fund significant fees and
expenses in connection with an investigation that may not be in the
fund's best interest. Further, as discussed above, we believe the
prohibited fees and expenses are related to forming and operating an
advisory business and thus should be borne by the adviser and its
owners rather than the private fund and its investors.
We do not anticipate this aspect of the proposed prohibited
activities rule would cause a dramatic change in practice for most
private fund advisers, other than for certain advisers that utilize a
pass-through expense model as noted above. We recognize, however, that
advisers often charge private funds for regulatory, compliance, and
other similar fees and expenses directly related to the activities of
the private fund. The proposed rule would not change this practice. For
example, the proposed rule would not prohibit an adviser from charging
a private fund for all the costs associated with a regulatory filing of
the fund, such as Form D.\158\ In addition, we acknowledge that it may
not be clear whether certain fees and
[[Page 16923]]
expenses relate to the fund or the adviser, or it may not be clear
until after a significant amount of time has passed in certain cases.
In these circumstances, an adviser generally should allocate such fees
and expenses in a manner that it believes in good faith is fair and
equitable and is consistent with its fiduciary duty.
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\158\ Advisers may be liable under the antifraud provisions of
the Federal securities laws if the private fund's offering and
organizational documents do not authorize such costs to be charged
to the private fund.
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We request comment on this aspect of the prohibited activities
rule, including the following items:
Are there circumstances in which it would be appropriate
in the public interest or for the protection of investors for a private
fund to bear (i) regulatory or compliance expenses of the adviser or
its related persons or (ii) expenses related to an examination or
investigation of the adviser or its related persons? If so, please
explain. Should we permit private funds to bear these fees and expenses
if fully disclosed and consented to by the private fund investors and/
or an LPAC (despite the limitations of private fund governance
mechanisms, as discussed above)? Should we place any conditions on
charging these fees and expenses, such as caps, management fee offsets,
or detailed reporting requirements in the proposed quarterly statement?
The proposed rule would likely increase operating costs
for advisers that have historically charged private funds for the types
of fees and expenses covered by the proposed rules.
Do commenters believe that advisers would increase management fees
to offset such increase in operating costs?
Are there any additional types of fees or expenses that we
should prohibit an adviser from charging to a private fund?
Alternatively, are there fees and expenses that the rule should not
prohibit?
Should we provide exceptions to the proposed rules for
certain types of private funds and/or certain types of advisers? For
example, should we permit a first-time fund adviser to charge
regulatory and compliance expenses to the fund? If so, why?
Do commenters agree that many advisers do not currently
charge private funds for the types of fees and expenses covered by the
proposed rules and, as a result, the proposed rules would not cause a
dramatic change in industry practice? Why or why not? To the extent
commenters disagree, please provide supporting data.
Will advisers have difficulty in determining whether fees
and expenses relate to the adviser's activities versus the fund's
activities? Should we provide guidance to assist advisers in making
such a determination? If so, what guidance should we provide? Should
the rule list certain types of fees and expenses that relate to the
adviser's activities versus the fund's activities?
As discussed above, we recognize that certain private fund
advisers utilize a pass-through expense model. Should the rule provide
any full or partial exceptions for advisers utilizing such models,
particularly where the adviser does not charge any management,
advisory, or similar fees to the private fund?
3. Reducing Adviser Clawbacks for Taxes
The fourth element of the prohibited activities rule would prohibit
an adviser from reducing the amount of any adviser clawback by actual,
potential, or hypothetical taxes applicable to the adviser, its related
persons, or their respective owners or interest holders. We propose to
define ``adviser clawback'' as any obligation of the adviser, its
related persons, or their respective owners or interest holders to
restore or otherwise return performance-based compensation to the
private fund pursuant to the private fund's governing agreements.\159\
We propose to define ``performance-based compensation'' as allocations,
payments, or distributions of capital based on the private fund's (or
its portfolio investments') capital gains and/or capital
appreciation.\160\
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\159\ Proposed rule 211(h)(2)-1(a)(4). Because performance-based
compensation may be allocated or granted to individuals and entities
otherwise unaffiliated with the adviser, the proposed definition is
drafted broadly to capture any owner or interest holder of the
adviser or its related persons.
\160\ Proposed rule 211(h)(1)-1. The proposed rule would not
apply to any clawbacks by an adviser of incentive compensation under
an arrangement subject to Section 956 of the Dodd-Frank Act and
regulations thereunder.
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Investors typically seek to align their interests with the
adviser's interest by tying the adviser's compensation to the success
of the private fund. To accomplish this, many private funds provide the
adviser with a disproportionate share of profits generated by the fund,
often referred to as performance-based compensation.\161\ The adviser's
performance-based share of fund profits is often greater than the
adviser's ownership percentage in the fund.\162\ Although the
percentage can vary, a common performance-based compensation percentage
is 20%, meaning that, for each dollar of profit generated by the fund,
the adviser is generally entitled to 20 cents and the fund investors
are generally entitled to the remaining 80 cents.
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\161\ Certain private funds refer to performance-based
compensation as carried interest, incentive fees, incentive
allocations, or profit allocations.
\162\ For alignment of interest purposes, advisers often invest
their own capital in the fund alongside the third party capital.
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Because the profitability of a private fund will fluctuate over
time, the amount of performance-based compensation to which the adviser
is entitled will also fluctuate. For example, a fund may initially
generate significant profits due to early realizations of successful
investments, resulting in distributions to the adviser. However, the
fund may subsequently dispose of unsuccessful investments, resulting in
losses to the fund. Certain private funds include ``clawback''
mechanisms in their governing agreements, which require the adviser (or
a related person of the adviser) \163\ to restore distributions or
allocations to the fund to the extent the adviser receives performance-
based compensation in excess of the amount to which it is otherwise
entitled under the fund's governing agreement. Typically, this means
that the adviser is required to return to the fund distributions or
allocations representing more than a specified percentage (e.g., 20%)
of the fund's aggregate profits. The clawback mechanism is intended to
ensure that the adviser and the investors ultimately receive the
appropriate split of cumulative profits generated over the life of the
fund or the applicable measurement period.
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\163\ For tax and other reasons, a related person of the
adviser, rather than the adviser, often receives the performance-
based compensation from the fund.
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Advisers and investors often negotiate whether the clawback amount
should be reduced by taxes paid, or deemed paid, by the adviser or its
owners.\164\ For example, if an adviser received $10 of ``excess''
performance-based compensation, but the adviser or its owners paid $3
in taxes on such amount, investors often argue that the adviser should
be required to return the ``pre-tax'' amount ($10), while advisers
argue that they should only be required to return the ``post-tax''
amount ($7). To support the post-tax position, advisers often argue
that they should only be required to return the portion of excess
[[Page 16924]]
distributions they ultimately retain (and not the portion paid to any
taxing authority). Advisers also argue that, to the extent the clawback
occurs in any year subsequent to the year in which the performance-
based compensation was paid, it may be burdensome or impractical for
the adviser or its owners to amend tax returns from prior years or
otherwise take advantage of loss carryforwards for future tax
years.\165\
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\164\ Fund agreements may require advisers to restore
performance-based compensation under other fact patterns as well.
For example, if an adviser has received performance-based
compensation, but the investors have not received the requisite
preferred return amount, the adviser may be subject to a clawback.
Any such requirement to restore or otherwise return performance-
based compensation under a private fund's governing agreement would
be covered by the proposed rule. See proposed rule 211(h)(1)-1
(defining ``adviser clawback'' as any obligation of the adviser, its
related persons, or their respective owners or interest holders to
restore or otherwise return performance-based compensation to the
private fund pursuant to the private fund's governing agreements).
\165\ When the clawback occurs in a subsequent tax year, the
``excess'' performance-based compensation will likely have already
been subject to tax in the year it was paid, even if the amount
subject to the clawback is determined on a pre-tax basis.
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We believe that reducing the amount of any adviser clawback by
taxes applicable to the adviser puts the adviser's interests ahead of
the investors' interests and creates a compensation scheme that is
contrary to the public interest and the protection of investors, even
where such practice is disclosed. The interests of investors to receive
their share of fund profits--without any adviser tax reductions--
justifies the burdens on advisers, including the obligation to amend
tax returns. Advisers typically have control over the methodology used
to determine the timing of performance-based compensation distributions
or allocations, such as any waterfall arrangement.\166\ Advisers also
typically have control over whether the fund will make a distribution
or allocation of performance-based compensation. Advisers thus have
discretion to defer or otherwise delay payments, particularly if the
adviser is concerned about the possibility of a clawback.\167\ Even if
an adviser cannot defer or delay a payment, the adviser can escrow
performance-based compensation rather than making a payment to its
owners, which would allow the adviser to cover all or a portion of a
clawback obligation that may arise in the future. Accordingly, the
proposed rule would foster greater alignment of interest between
advisers and investors by prohibiting advisers from unfairly causing
investors to bear these tax costs associated with the payment,
distribution, or allocation of ``excess'' performance-based
compensation.
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\166\ Private fund investors often seek to negotiate the
waterfall arrangement, and the timing of performance-based
compensation distributions, with the adviser. The issues relating to
clawbacks often arise in the context of a waterfall arrangement that
provides performance-based compensation to the adviser on a deal-by-
deal basis (or modified versions thereof), versus a waterfall
arrangement that is applied across the whole-fund with distributions
going to investors until the investors recoup 100% of their capital
contributions and receive a preferred return thereon. Both models
should generally result in the adviser and the investors receiving
the same split of fund profits over the life of the fund assuming
the fund documents have a clawback mechanism. The main distinction
between the two models is the timing of distributions or allocations
of performance-based compensation to the adviser. Whole-fund
waterfalls are often referred to in the private funds industry as
European waterfalls; deal-by-deal waterfalls are often referred to
as American waterfalls.
\167\ We recognize that an adviser (and its personnel) may be
subject to a tax obligation whether or not the fund makes a
distribution, payment, or allocation of performance-based
compensation (e.g., tax allocations of income may precede or follow
cash payments of performance-based compensation), including if the
adviser places the performance-based compensation into escrow.
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We request comment on this aspect of the proposed rule, including
the following items:
Would this aspect of the proposed prohibited activities
rule have our intended effect of ensuring that investors receive their
full share of profits generated by the fund? Is there an alternative
approach that would better produce this intended effect? For example,
should we require advisers to return the entire amount of any adviser
clawback, rather than only prohibiting advisers from reducing the
clawback amount by actual, potential, or hypothetical taxes? Would this
approach ensure that investors receive their full share of fund
profits?
Would the proposed clawback provision result in more
whole-fund waterfalls (commonly referred to as European waterfalls in
the private funds industry), which generally delay payments of
performance-based compensation until investors receive a return of all
capital contributions? What other effects would this aspect of the
proposed rule have on the industry, including with respect to adviser's
ability to attract, retain, and develop investment professionals?
Instead of the proposed clawback provision, should we
prohibit deal-by-deal waterfall arrangements (commonly referred to as
American waterfalls)?
We recognize that clawback mechanisms are more common for
closed-end funds and less common for open-end funds. Should the rule
separately address performance-based compensation for open-end private
funds? If so, how should we address those funds?
Is the proposed definition of ``adviser clawback'' clear?
Are there ways in which the proposed definition is over- or under-
inclusive? For example, should the definition include ``all-partner''
givebacks or clawbacks (i.e., should advisers be prohibited from
reducing the portion of an all-partner giveback attributable to their
performance-based compensation by taxes paid or deemed paid)?\168\
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\168\ An ``all-partner'' giveback is typically a requirement for
all investors to return or otherwise restore distributions to the
fund. An adviser may use this mechanism for the purpose of
satisfying fund obligations, liabilities, or expenses.
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Is the proposed definition of ``performance-based
compensation'' clear? Is it too narrow or too broad?
What issues may advisers face in complying with this
aspect of the proposed prohibited activities rule? In particular, what
issues may result with respect to amending tax returns from prior
years?
We recognize that this aspect of the proposed rule might
result in delayed payments of performance-based compensation. For
example, during the early stages of the fund, the adviser may be less
inclined to distribute performance-based compensation to investment
professionals that source or manage successful investments. How would
this aspect of the proposed prohibited activities rule affect the
intended incentive effects of performance-based compensation?
We recognize that many fund agreements clawback
performance-based compensation on a post-tax basis. We considered, but
are not proposing, a rule that would generally allow this practice to
continue, but would prohibit advisers from using a hypothetical
marginal tax rate to determine the tax reduction amount.\169\ We
considered requiring advisers to use the actual marginal tax rates
applicable to the adviser or its owners, rather than a hypothetical
marginal tax rate. Our view is that this approach could be too
burdensome for advisers. Do commenters agree? If we were to adopt this
approach, how should we factor tax benefits realized by the adviser or
its owners into the tax reduction amount? What operational challenges
would advisers face under this alternative approach? For example, would
the amount of time it may take to determine
[[Page 16925]]
the actual tax amount, which may not be determined until a significant
amount of time has passed not justify the benefits? Do commenters
believe that the use of a hypothetical marginal tax rate is a
reasonable and cost-effective method for determining the tax reduction
amount, or do commenters believe that the hypothetical marginal tax
rate is too high? Why or why not? Please provide data.
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\169\ Because many entities that receive performance-based
compensation are fiscally transparent for U.S. Federal income tax
purposes and thus not subject to entity-level taxes, determining the
actual taxes paid on ``excess'' performance-based compensation can
be challenging, particularly for larger advisers that have not only
a significant number of participants that receive such compensation
but also have participants subject to non-U.S. tax regimes. To
address this problem, advisers typically use a ``hypothetical
marginal tax rate'' to determine the tax reduction amount, which is
usually based on the highest marginal U.S. Federal, state, and local
tax rates. Advisers argue that this approach is a reasonable and
cost-effective method for determining the tax reduction amount;
investors argue that the hypothetical rate is too high and therefore
reduces the clawback amount to their detriment.
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4. Limiting or Eliminating Liability for Adviser Misconduct
The fifth element of the proposed prohibited activities rule would
prohibit an adviser to a private fund, directly or indirectly, from
seeking reimbursement, indemnification, exculpation, or limitation of
its liability by the private fund or its investors for a breach of
fiduciary duty, willful misfeasance, bad faith, negligence, or
recklessness in providing services to the private fund.
Currently, many private funds and/or their investors enter into
documents containing such contractual terms. Our staff has observed
private fund agreements with waiver and indemnification provisions that
have become more aggressive over time. For example, our staff recently
encountered many limited partnership agreements that state that the
adviser to the private fund or its related person, which is the general
partner to the fund, to the maximum extent permitted by applicable law,
will not be subject to any duties or standards (including fiduciary or
similar duties or standards) existing under the Advisers Act, Delaware
law, or Cayman Islands law or will not be liable to the fund or
investors for breaching its duties (including fiduciary duties) or
liabilities (that exist at law or in equity).\170\
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\170\ See, e.g., EXAMS Private Funds Risk Alert 2022, supra
footnote 16 (discussing hedge clauses). See also Comment Letter of
the Institutional Limited Partners Association on the Proposed
Commission Interpretation Regarding Standard of Conduct for
Investment Advisers; Request for Comment on Enhancing Investment
Adviser Regulation (Aug. 6, 2018), File No. S7-09-18, at 6,
available athttps://ilpa.org/wp-content/uploads/2018/08/ILPA-Comment-Letter-on-SEC-Proposed-Fiduciary-Duty-Interpretation-August-6-2018.pdf. See also Protecting LLC Owners While Preserving LLC
Flexibility, University of California, Davis Law Review, 51 U.C.
Davis L. Rev. 2129, 2133, Professor Peter Molk (2018) (discussing
scenarios in which an investor is induced to ``sign away fundamental
protections'' without understanding the importance of those
protections, without understanding the meaning of certain legal
terms, and sometimes without reading the documents the investor
signs).
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While these contractual terms may be permissible under certain
state laws, a waiver of an adviser's compliance with its Federal
antifraud liability for breach of fiduciary duty to the private fund or
with any other provision of the Advisers Act or rules thereunder is
invalid under the Act.\171\ The prohibited activities rule would
specify the types of contractual provisions that would be invalid.\172\
For instance, it would prohibit an adviser from seeking indemnification
for breaching its fiduciary duty, regardless of whether state or other
law would permit an adviser to waive its fiduciary duty. The proposed
rule would also prohibit an adviser from seeking reimbursement for its
willful malfeasance. This scope of prohibitions is appropriate because
these activities harm investors by placing the adviser's interests
above those of its private fund clients (and investors in such
clients). By limiting an adviser's responsibility for breaching the
standard of conduct, the incentive to comply with the required standard
of conduct is eroded. We believe such contractual provisions are
neither in the public interest nor consistent with the protection of
investors, particularly where investors are led to believe the adviser
is contractually not obligated to comply with certain provisions of the
Act or rules thereunder, or where investors with less bargaining power
are forced to bear the brunt of such arrangements.\173\
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\171\ See section 215(a) of the Advisers Act; 2019 IA Fiduciary
Duty Interpretation, supra footnote 140 (stating that an adviser's
Federal fiduciary obligations are enforceable through section 206 of
the Advisers Act and that the SEC would view a waiver of enforcement
of section 206 as implicating section 215(a) of the Advisers Act.
Section 215(a) of the Advisers Act provides that any condition,
stipulation or provision binding any person to waive compliance with
any provision of the title shall be void.).
\172\ See section 215(b) of the Advisers Act (stating that any
contract made in violation of the Act or rules thereunder is void).
\173\ See Professor Clayton Article, supra footnote 7, at 309
(noting that ``LPAs have been criticized for waiving and otherwise
limiting managers' fiduciary duties to their investors under state
limited partnership law; for seeking to satisfy managers' fiduciary
duties under Federal law by providing generic and all-encompassing
disclosures . . . for requiring investors to indemnify managers for
liabilities resulting from an extremely broad array of conduct,
including criminal acts committed by managers''). See also The
Private Equity Negotiation Myth, Yale Journal on Regulation Vol.
37:67, Professor William Clayton (2020), at p. 70 (noting that
``large investors in private equity funds commonly use their
bargaining power to negotiate for individualized benefits outside of
fund agreements, where the benefit of the bargain is not shared with
other investors in the fund . . . an investor can use its bargaining
power to negotiate for individualized benefits before it negotiates
for things that will benefit all investors in the fund.''); ILPA
Model Limited Partnership Agreement (July 2020) (suggesting standard
of care, exculpation, and indemnification language in order to
reduce the cost, time and complexity of negotiating the terms of
investment).
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We request comment on this aspect of the proposed rule, including
the following items:
We have observed these types of contractual provisions
among private fund advisers and their related persons; do advisers to
clients other than private funds typically include these types of
contractual provisions?
Are there other types of contractual provisions we should
prohibit as contrary to the public interest and the protection of
investors?
Should this aspect of the final prohibited activities rule
prohibit limiting liability for ``gross negligence,'' or would
prohibiting limitations of liability for ordinary negligence, as
proposed, be more appropriate? Why?
Should the proposed rule prohibit contractual provisions
that limit or purport to waive fiduciary duties and other liabilities
in situations where state law permits such waivers?
Do commenters believe that the proposed rule would
increase operating expenses for advisers? For example, would the
proposed prohibition on receiving indemnification/exculpation for
negligence cause an adviser's insurance premium to increase?
5. Certain Non-Pro Rata Fee and Expense Allocations
The sixth element of the prohibited activities rule would prohibit
an adviser from directly or indirectly charging or allocating fees and
expenses related to a portfolio investment (or potential portfolio
investment) on a non-pro rata basis when multiple private funds and
other clients advised by the adviser or its related persons have
invested (or propose to invest) in the same portfolio investment.\174\
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\174\ Proposed rule 211(h)(2)-1(a)(6).
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An adviser may cause a private fund and one or more other vehicles
to invest in an issuer or entity in which other related funds or
vehicles have, or are concurrently making, an investment. For example,
an adviser may form a parallel fund in a non-U.S. jurisdiction, such as
Luxembourg, to accommodate certain European or other non-U.S. investors
that invests alongside the adviser's main fund in all, or substantially
all, of its investments. An adviser also may form more bespoke
structures for large or strategic investors, such as separate accounts,
funds of one, and co-investment vehicles, that invest alongside other
funds managed by the adviser that have similar or overlapping
investment strategies.
An adviser can face conflicts of interest where multiple clients
(and/or other persons advised by the adviser) invest, or propose to
invest, in the same portfolio investment, especially with respect to
allocating fees and expenses among those clients (or such other
[[Page 16926]]
persons).\175\ We believe that any non-pro rata allocation of fees and
expenses under these circumstances is contrary to the protection of
investors because it would result in the adviser placing its own
interest ahead of another's, including in circumstances where the
adviser indirectly benefits by placing the interests of one or more
clients or investors ahead of another's.\176\ For example, a fund may
not have the resources to bear its pro rata share of expenses related
to a portfolio investment (whether due to insufficient reserves, the
inability to call capital to cover such expenses, or otherwise). If the
adviser causes another fund to bear expenses attributable to such fund,
the fund bearing more than a pro rata share would be supporting the
value of the other fund's investment.\177\ Because compensation
structures in the funds may differ, an adviser may have an incentive to
allocate fees and expenses in a way that maximizes its compensation.
Further, an adviser's ownership may vary fund by fund and thus may
create an incentive to allocate fees and expenses away from the fund in
which the adviser holds a greater interest.\178\
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\175\ See EXAMS Private Funds Risk Alert 2020, supra footnote 9.
See also, e.g., In the Matter of Rialto Capital Management, LLC,
Investment Advisers Act Release No. 5558 (Aug. 7, 2020) (settled
action) (alleging that adviser represented to the advisory
committee, which included private fund investors as committee
members, that it had data to support the adviser performing third-
party services in house and charging the funds certain rates; and
that the adviser misallocated fees for third-party services to the
private funds when such fees also should have been allocated to the
co-investment vehicles managed by the adviser).
\176\ Because the proposed rule prohibits charging or allocating
fees and expenses related to a portfolio investment (or potential
portfolio investment) on a non-pro rata basis, advisers would not be
prohibited from charging vehicles that invest alongside each other
different advisory fees or other fund-level compensation. For
example, a co-investment vehicle may pay lower management fees than
the main fund.
\177\ The proposed rule would not prohibit an adviser from
paying a fund's pro rata portion of any fee or expense with its own
capital. In addition, to the extent a fund does not have resources
to pay for its share, the proposed rule would not prohibit an
adviser from diluting such fund's interest in the portfolio
investment in a manner that is economically equal to its pro rata
portion of such fee or expense.
\178\ On a more granular level, to the extent the adviser's
personnel have varying ownership percentages in the funds, such
personnel may be subject to similar conflicts of interest in
determining how to allocate fees and expenses.
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Moreover, we do not believe that fees and expenses attributable to
unconsummated--or potential--portfolio investments should be treated
differently than consummated investments, given that non-pro rata
allocations in respect of unconsummated investments generally present
the same concerns as discussed above with respect to consummated
investments. If more than one fund would have participated in an
investment that generated ``broken deal'' or other fees and expenses,
our view is that all such funds should bear their pro rata share of
such amount.
We recognize that many advisers do not charge all their clients or
potential co-investors for fees and expenses relating to unconsummated
investments. For example, certain advisers offer existing investors,
related persons, or third parties the opportunity to co-invest
alongside the fund through one or more co-investment vehicles advised
by the adviser.\179\ Many advisers do not charge co-investment vehicles
or other co-investors for fees and expenses relating to unconsummated
investments. Instead, such fees and expenses are generally borne by the
adviser's main fund that would have participated in the transaction, in
which case the main fund would bear a disproportionate share of such
amount. Such practice, however, places the interests of the other
client and its underlying investors or of the other co-investors ahead
of the interests of the main fund and its underlying investors. 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. Accordingly, the proposed rule does not include an
exception for these types of circumstances.\180\
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\179\ In some cases, advisers use co-investment opportunities to
attract new investors and retain existing investors. Advisers may
offer these existing or prospective investors the opportunity to
invest in co-investment vehicles with materially different fee and
expense terms than the main fund (e.g., no fees or no obligation to
bear broken deal expenses). These co-investment opportunities may
raise conflicts of interest, particularly when the opportunity to
invest arises because of an existing investment and the fund itself
would otherwise be the sole investor.
\180\ To the extent a potential co-investor has not executed a
binding agreement to participate in the transaction through a co-
investment vehicle (or another fund) managed by the adviser, the
proposed rule would not prohibit the adviser from allocating
``broken-deal'' or other fees and expenses attributable to such
potential co-investor to a fund that would have participated in the
transaction. Advisers may be liable under the antifraud provisions
of the Federal securities laws if the private fund's offering and
organizational documents do not authorize such costs to be charged
to the private fund.
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We request comment on this aspect of the proposed prohibited
activities rule, including the following items:
Should we prohibit non-pro rata fee and expense
allocations as proposed? If not, under what circumstances would non-pro
rata allocations be appropriate? For example, we recognize that
advisers often have policies and procedures in place that permit the
adviser to allocate fees and expenses in a fair and equitable manner
(or similar standard), rather than on a pro rata basis; would this
better achieve our policy goals? Why or why not? What specific
protections are included in such policies and procedures? Should such
protections be included in the rule? Why or why not? Should there be an
exception to the prohibition where an adviser determines that it is in
a private fund's best interest to bear more expenses than another
managed vehicle and the private fund's investors agree?
Should the proposed rule apply to unconsummated--or
potential--portfolio investments, as proposed? Do commenters agree that
non-pro rata allocations of fees and expenses attributable to such
investments present the same concerns as the ones discussed above with
respect to consummated investments? Why or why not?
We recognize that many co-investors do not agree to bear
their pro rata share of broken or dead deal expenses. Would the
proposed rule make it difficult for funds to consummate larger
investments where co-investment capital is needed? Would the proposed
rule cause funds to syndicate more deals post-closing once the adviser
is confident that the deal will not fall through?
Should we include an exception for co-investment vehicles
(or certain other vehicles) that invest alongside another fund managed
by the adviser? If so, how should we define ``co-investment vehicle''?
Should the rule treat single-deal co-investment vehicles differently
than multi-deal co-investment vehicles? Why or why not?
Should we define ``pro rata''? Should ``pro rata'' be
determined based on each client's ownership (or anticipated ownership)
of the portfolio investment? Will advisers interpret ``pro rata''
differently?
Where multiple funds invest in the same portfolio
investment at different times, the first fund to invest may initially
bear a higher level of fees and expenses than later funds. Should the
proposed rule address fees and expense allocations among funds that
invest at different times, and if so, how? If a significant amount of
time has passed between the first fund's investment and the later
fund's investment, should the later fund pay interest on its portion of
fees and expenses? Should interest payments always apply when portfolio
investments are made at different times?
[[Page 16927]]
If not, how much time should lapse before interest applies?
The proposed rule would prohibit advisers from charging or
allocating fees and expenses related to a portfolio investment (or
potential portfolio investment) on a non-pro rata basis when multiple
private funds and other clients advised by the adviser or its related
persons have invested (or propose to invest) in the same portfolio
investment. Is the scope of the phrase ``other clients advised by the
adviser or its related persons'' broad enough? Should we revise the
proposed rule to cover any other clients, vehicles, or other persons
advised by the adviser or its related persons? Alternatively, should we
revise the rule to cover all co-investment structures and arrangements?
We recognize that a transaction counterparty may request
to only contract with one fund entity, which can result in one fund
being liable for its own share as well as another fund's share of any
transaction obligations, including fees and expenses. If one fund would
be responsible for the liability of another fund, those funds, in
certain cases, contractually agree to bear their pro rata share, often
times through a contribution or reimbursement agreement. Should we
prohibit this practice and thus require each fund entity to contract
directly with the counterparty? Alternatively, should we require
certain governance and other protections, such as contribution or
reimbursement agreements, if only one fund contracts directly with the
counterparty? Why or why not?
As noted above, the proposed rule would not prohibit an
adviser from charging different fund-level compensation, such as
advisory fees, to vehicles that invest alongside each other in the same
underlying portfolio investment. For example, a co-investment vehicle
may pay lower management fees than the main fund. Is it sufficiently
clear that such arrangements would not be prohibited under the proposed
rule?
6. Borrowing
The final element of the proposed prohibited activities rule would
prohibit an adviser directly or indirectly from borrowing money,
securities, or other fund assets, or receiving a loan or an extension
of credit, from a private fund client (collectively, a
``borrowing'').\181\ We have observed many forms of borrowing among
private fund advisers and their related persons, such as using fund
assets as collateral in order to obtain a loan from a party other than
the fund (i.e., borrowing against fund assets), accepting a loan
offered by a private fund client, and taking advantage of a continuous
line of credit extended by a private fund client. For example, the
Commission has brought enforcement actions alleging that private fund
advisers and their related persons have used fund assets to address
personal financial issues of one of the adviser's principals, to pay
for the advisory firm's expenses,\182\ or to bribe foreign government
officials.\183\ In these circumstances, the adviser's related person
that is the general partner of the fund sometimes, for example, causes
the fund to enter into the relationship with the adviser without the
knowledge or consent of the private fund investors.
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\181\ Proposed rule 211(h)(2)-1(a)(7).
\182\ See In the Matter of Monsoon Capital, LLC, Investment
Advisers Act Release No. 5490 (Apr. 30, 2020) (settled action)
(alleging that the owner of a private fund adviser borrowed $1
million from a private fund client in order to settle a personal
trade); Resilience Management, LLC, Investment Advisers Act Release
No. 4721 (June 29, 2017) (settled action) (alleging that a private
fund adviser borrowed money from funds in order to pay adviser's
expenses; and that the CEO of the adviser borrowed money to pay for
personal expenses); SEC v. Philip A. Falcone, [U.S. District Court
Southern District of New York, Consent] (Aug. 16, 2013) (hedge fund
adviser borrowed from hedge fund at low interest rate in order to
repay adviser's personal taxes. Adviser failed to disclose the loan
to investors for five months).
\183\ See In the Matter of Och-Ziff Capital Management Group,
LLC, Investment Advisers Act Release No. 4540 (Sept. 29, 2016), at
para. 3 (settled action) (alleging that a private fund adviser
authorized the use of investor funds to pay bribes to foreign
government officials in order to obtain or retain business for its
parent company and its business partners).
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When an adviser borrows from a private fund client, that adviser
has a conflict of interest because it is on both sides of the
transaction (i.e., the adviser benefits from the loan and manages the
client lender). A private fund rarely has employees of its own. Its
officers, if any, are usually employed by the private fund's adviser.
The fund typically relies on the investment adviser (and, in certain
cases, affiliated entities) to provide management, investment, and
other services and such persons usually have authority to take actions
on behalf of the private fund without the consent or approval of any
other person. This structure causes a conflict of interest between the
private fund (and, by extension, its investors) and the investment
adviser because the interests of the fund are not necessarily aligned
with the interests of the adviser. For example, when determining the
interest rate for the borrowing, an investment adviser's interest in
maximizing its own profit by negotiating (or setting) a low rate may
conflict with its duty to act in the best interests of the fund.
Moreover, this practice may prevent the fund client from using
those assets to further the fund's investment strategy. Even where
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 private
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.
The proposed rule would not prevent the adviser from borrowing from
a third party on the fund's behalf or from lending to the fund. Private
funds sometimes use subscription lines of credit, also known as credit
facilities, to address financing needs. For example, some private funds
use these facilities to address short-term financing needs when the
fund makes investments or participates in a co-investment. Other
private funds use such facilities for long-term financing purposes, for
example, when an infrastructure fund decides to use a long-term
facility during the development stage of a project before a capital
call. In these circumstances, the adviser is not borrowing from the
fund. Similarly, advisers sometimes lend money to a fund in order to
address start-up costs or to manage other expenses (for example, an
adviser may pay legal or operating expenses of several fund clients and
then seek reimbursement once the expenses have been allocated among the
advised private funds). Allowing advisers to continue this practice
would provide private funds access to capital, especially when they are
in the early stages of attracting investors. Advisers lending to
private funds they manage on terms that do not include excessive
interest rates or other abusive practices do not raise the same
concerns that advisers borrowing from private funds they manage raises
because there are fewer opportunities for abusive practices when the
adviser is providing money to, rather than taking money from, the
private fund.
We request comment on this aspect of the proposed prohibitions
rule, including the following:
Should we broaden the scope of the prohibition on
borrowings to prevent a private fund adviser from borrowing from co-
investment vehicles or other accounts that are not private funds?
[[Page 16928]]
Should we broaden the proposed prohibition to apply when
an adviser lends to the fund? \184\
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\184\ See, e.g., In the Matter of Clean Energy Capital LLC,
Investment Advisers Act Release No. 3955 (Oct. 17, 2014) (settled
action) (alleging that a private equity fund adviser caused the
funds to borrow money from the adviser without providing notice to
investors and by pledging the private equity funds' assets as
collateral).
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Should the proposed rule exclude certain activity from the
prohibition (e.g., scenarios where a private fund makes tax advances or
tax distributions to its general partner (or similar control person) to
ensure that the general partner and its investment professionals are
able to pay their personal taxes derived from the general partner's
interest in the fund)? If so, what activity should we exclude and why?
Are there situations in which a fund would agree to lend a
start-up adviser money for initial costs and employee salaries? Are
there situations in which a private fund client should be able to make
a loan to a private fund adviser because the economic terms would be
favorable to the private fund? How would we determine that the terms
are favorable to the private fund?
Should the proposed rule be expanded to prohibit an
adviser from borrowing against a private fund client's bank account or
other assets, where the lender may be a third party (rather than the
private fund)? Why or why not?
Should we amend Form ADV and/or Form PF to require
advisers to report information about an adviser or its related person
lending to, or borrowing from, private funds or other clients? Why or
why not? For example, should we require advisers to report whether they
engage in this practice and to provide an aggregate amount or range of
such loans or borrowings?
Recognizing the limitations of private fund governance
mechanisms, as discussed above, should we permit borrowing if it is
subject to specific governance and other protections (e.g., advance
disclosure to all investors, advance disclosure to an LPAC or similar
body, consent of a governing body such as an LPAC, and/or consent of a
majority or supermajority of investors)? Should we require private fund
advisers to make ongoing disclosures to investors and/or governing
bodies of the status of such borrowings? Why or why not?
Should the rule include any full or partial exclusions for
certain transactions that may not involve conflicts of interest or that
may involve certain third parties that ameliorate the conflicts of
interest? For example, should we provide an exclusion if the terms of
the borrowing are set by an independent third party and such third
party has the authority to act on behalf of the fund in the event of a
default by the adviser? Why or why not?
Do commenters envision unintended consequences of this
proposed prohibition, such as in circumstances where an adviser's
related person has its own commercial relationship with the fund?
Should the rule prohibit (or otherwise restrict) advisers
from lending to private funds they manage on terms that include
excessive interest rates or other abusive practices? To what extent and
under what circumstances does this practice occur? Does it raise
similar concerns to borrowing?
E. Preferential Treatment
In order to address specific types of preferential treatment that
have a material negative effect on other investors in the private fund
or in a substantially similar pool of assets, we also propose to
prohibit all private fund advisers, regardless of whether they are
registered with the Commission, from providing preferential terms to
certain investors regarding redemption or information about portfolio
holdings or exposures.\185\ We also propose to prohibit these advisers
from providing any other preferential treatment to any investor in the
private fund unless the adviser provides written disclosures to
prospective and current investors in a private fund regarding all
preferential treatment the adviser or its related persons are providing
to other investors in the same fund.\186\ Whether any terms are
``preferential'' would depend on the facts and circumstances.
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\185\ Proposed rule 211(h)(2)-3(a)(1) and (2).
\186\ Proposed rule 211(h)(2)-3(b).
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Side letters or side arrangements are generally agreements among
the investor, general partner, adviser, and/or the private fund that
provide the investor with different or preferential terms than those
set forth in the fund's governing documents.\187\ Side letters
generally grant more favorable rights and privileges to certain
preferred investors (e.g., seed investors, strategic investors, those
with large commitments, and employees, friends, and family) or to
investors subject to government regulation (e.g., the Employee
Retirement Income Security Act (``ERISA''), the Bank Holding Company
Act, or public records laws). Advisers often provide these terms for
strategic reasons that benefit the adviser. In some cases, these terms
can also benefit the fund, for example, if the adviser signs a side
letter with a large, early stage investor, then the fund will increase
its assets. Increased fund assets may enable the fund to make certain
investments, for example of a larger size, which ultimately benefits
all investors. However, preferential terms do not necessarily benefit
the fund or other investors that are not party to the side letter
agreement and, at times, we believe these terms can have a material,
negative effect on other investors.
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\187\ The proposed rule would prohibit certain types of
preferential treatment and would require an adviser to disclose
other types of preferential treatment that the adviser or its
related persons (acting on their own behalf and/or on behalf of the
fund) provide to investors. Therefore, the proposed rule typically
would apply when the adviser's related person is the general partner
(or similar control person) and is a party (and/or caused the
private fund to be a party, directly or indirectly) to a side letter
or other arrangement with an investor, even if the adviser itself
(or any related person of the adviser) is not a party to the side
letter or other arrangement.
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We recognize that advisers provide a range of preferential
treatment, some of which does not necessarily disadvantage other fund
investors. In this case, we believe that disclosure is appropriate
because it would allow investors to make their own assessment. Other
types of preferential treatment, however, have a material, negative
effect on other fund investors or investors in a substantially similar
pool of assets. We propose to prohibit these types of preferential
treatment because they are sales practices that present a conflict of
interest between the adviser and the private fund client that are
contrary to the public interest and protection of investors. We have
tailored the proposed rule to address these different ends of the
spectrum.
Prohibited Preferential Redemptions
We propose to prohibit a private fund adviser, including indirectly
through its related persons, from granting an investor in the private
fund or in a substantially similar pool of assets the ability to redeem
its interest 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.\188\
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\188\ Proposed rule 211(h)(2)-3(a)(1). For purposes of the
prohibitions in proposed rule 211(h)(2)-3(a)(1) or (2), whether an
adviser could have a reasonable expectation that the preferential
term would have a material, negative effect on other investors in
the same private fund or in a substantially similar pool of assets
would depend on the facts and circumstances.
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Different types of private funds and other pooled vehicles offer
different redemption opportunities, and an investor's ability to exit
or withdraw differs significantly depending on the fund's or pool's
liquidity profile. While open-end private funds typically allow
[[Page 16929]]
for periodic redemptions, closed-end private funds typically do not
permit investors to withdraw their investments without consent. We
understand that some private fund advisers grant one or more investors
more favorable redemption rights. For example, a large investor may
negotiate, through a side letter or other side arrangement, to be able
to redeem its interest in the fund before, or more frequently than,
other investors. Advisers enter into such arrangements in exchange for,
for example, a large investor agreeing to invest in the fund or a large
investor agreeing to participate in a future fundraising of an
investment vehicle that the adviser manages.\189\ Our staff also has
observed scenarios where an adviser establishes investment vehicles
that invest side-by-side along with the private fund that have better
liquidity terms than the terms provided to investors in the private
fund.\190\
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\189\ See supra section II.E. (Preferential Treatment)
(discussing side letters as a sales practice).
\190\ See EXAMS Private Funds Risk Alert 2020, supra footnote 9.
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We believe that granting preferential liquidity terms on terms that
the adviser reasonably expects to have a material, negative effect on
other investors in the private fund or in a substantially similar pool
of assets is a sales practice that is harmful to the fund and its
investors. In granting preferential liquidity rights to a large
investor, the adviser stands to benefit because its fees increase as
fund assets under management increase. As noted above, the adviser
attracts preferred investors to invest in the fund by offering
preferential terms, such as more favorable liquidity rights. While the
fund also may experience some benefits, including the ability to
attract additional investors and to spread expenses over a broader
investor and asset base, there are scenarios where the preferential
liquidity terms harm the fund and other investors. For example, if an
adviser allows a preferred investor to exit the fund early and sells
liquid assets to accommodate the preferred investor's redemption, the
fund may be left with a less liquid pool of assets, which can inhibit
the fund's ability to carry out its investment strategy or promptly
satisfy other investors' redemption requests. This can dilute remaining
investors' interests in the fund and make it difficult for those
investors to mitigate their investment losses in a down market cycle.
These concerns can also apply when an adviser provides favorable
redemption rights to an investor in a substantially similar pool of
assets, such as another feeder fund investing in the same master fund.
The Commission believes that the potential harms to other investors
justify this restriction.
Prohibited Preferential Transparency
We propose to prohibit an adviser and its related persons from
providing information regarding the portfolio holdings or exposures of
the private fund or of a substantially 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 substantially similar pool of assets.\191\
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\191\ Proposed rule 211(h)(2)-3(a)(2).
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Private fund advisers, in some cases, disclose information about
portfolio holdings or exposures to certain, but not all, investors in
the private fund or in a substantially similar pool of assets. For
example, an investor may request certain information about
characteristics of the fund's holdings to satisfy the investor's
internal reporting obligations. An investor can negotiate to receive
certain types of information that is not widely available to all
investors; however, an investor's success in obtaining such terms may
depend on factors including the size of its capital commitment.\192\
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\192\ See Professor Clayton Article, supra footnote 7, at 316
(noting that large investors can often negotiate fee discounts or
other side letter benefits that smaller investors would not
receive).
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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.
Granting preferential transparency, for example through side letters,
presents a sales practice that is contrary to the public interest and
protection of investors because it preferences one investor at the
expense of another. An adviser may agree to provide preferential
information rights to a certain investor in exchange for something of
benefit to the adviser. The proposed rule is designed to neutralize the
potential for private fund advisers to treat portfolio holdings
information as a commodity to be used to gain or maintain favor with
particular investors.\193\ We believe that this proposed prohibition
would curtail activity that harms investors.
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\193\ See Selective Disclosure and Insider Trading, Securities
Act of 1933 Release No. 33-7881 (Aug. 15, 2000) [65 FR 51715 (Aug.
24, 2000)].
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Substantially Similar Pool of Assets
The proposed rule would define the term ``substantially similar
pool of assets'' as a pooled investment vehicle (other than an
investment company registered under the Investment Company Act of 1940
or a company that elects to be regulated as such) with substantially
similar investment policies, objectives, or strategies to those of the
private fund managed by the adviser or its related persons.\194\
Whether a pool of assets managed by the adviser is ``substantially
similar'' to the private fund requires a facts and circumstances
analysis. A pool of assets with a materially different target return or
sector focus, for example, would likely not have substantially similar
investment policies, objectives, or strategies as the subject private
fund, depending on the facts and circumstances.
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\194\ Proposed rule 211(h)(1)-1.
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The types of asset pools that would be included in this term would
include a variety of pools, regardless of whether they are private
funds. For example, this term would include limited liability
companies, partnerships, and other organizational structures,
regardless of the number of investors; feeders to the same master fund;
and parallel fund structures and alternative investment vehicles. It
would also include pooled vehicles with different base currencies and
pooled vehicles with embedded leverage to the extent such pooled
vehicles have substantially similar investment policies, objectives, or
strategies as those of the subject private fund. In addition, an
adviser would be required to consider whether its proprietary accounts
meet the definition of ``substantially similar pool of assets.''
This proposed definition is designed to capture most commonly used
fund structures and prevent advisers from structuring around the
prohibitions on preferential treatment. For example, in a master-feeder
structure, some advisers create custom feeder funds for favored
investors. Without a comprehensive definition of substantially similar
pool of assets, the proposed rule would not preclude such advisers from
providing preferential treatment to investors in these custom feeder
funds to the detriment of investors in standard commingled feeder funds
within the master-feeder structure. While similar concerns may exist
for separately managed accounts, this proposed rule is designed to
address the specific concerns that arise out of the lack of
[[Page 16930]]
transparency and governance mechanisms prevalent in the private fund
structure.
Other Preferential Treatment
The proposed rule also would prohibit other preferential terms
unless the adviser provides certain written disclosures to prospective
and current investors.\195\ We believe that certain types of
preferential terms raise relatively minor concerns, if fully disclosed.
However, we are concerned that an adviser's current sales practices do
not provide all investors with sufficient detail regarding preferential
terms granted to other investors.\196\ For example, an adviser to a
private equity fund may provide ``excuse rights'' (i.e., the right to
refrain from participating in a specific investment the private fund
plans to make) to certain private fund investors. Advisers sometimes
grant excuse rights to accommodate an investor's unique investment
restrictions, such as a mandate to avoid investment in portfolio
companies that do not meet certain environmental, social, or governance
standards. This lack of transparency prevents investors from
understanding the scope of preferential terms granted. The proposed
rule would prohibit these terms unless the adviser provides information
about them in a written notice.
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\195\ Proposed rule 211(h)(2)-3(b).
\196\ See Juliane Begenau and Emil Siriwardane, How Do Private
Equity Fees Vary Across Public Pensions?, Harvard Business School
(2020), available at https://www.hbs.edu/faculty/Pages/item.aspx?num=57534.
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Increased transparency would better inform investors regarding the
breadth of preferential treatment, the potential for those terms to
affect their investment in the private fund, and the potential costs
(including compliance costs) associated with these preferential
terms.\197\ This disclosure would help investors shape the terms of
their relationship with the adviser of the private fund. For example,
they might also learn of similarly situated investors who are receiving
a better deal with respect to fees or other terms. An investor also may
learn that the adviser provided fee discounts to a large, early stage
investor. Or, an investor may learn that the adviser granted a
strategic investor the right to increase its investment in the fund
even though the fund is closed to new investors or to additional
investments by other existing investors. This may lead the investor to
request additional information on other benefits that the adviser's
related persons or large investors receive, such as co-investment
rights. An investor may then be able to understand better certain
potential conflicts of interest and the risk of potential harms or
other disadvantages.
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\197\ The Alternative Investment Fund Managers Directive (AIFMD)
includes transparency obligations requiring disclosure to all
investors of any preferential treatment received by a particular
investor, including by way of a side letter. See AIFMD Art. 23.
---------------------------------------------------------------------------
Under the proposed rule, 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), in order to
provide specific information as required by the proposed rule. An
adviser could comply with the proposed disclosure requirements by
providing copies of side letters (with identifying information
regarding the other investors redacted).\198\ Alternatively, an adviser
could provide a written summary of the preferential terms provided to
other investors in the same private fund, provided the summary
specifically describes the preferential treatment.
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\198\ We are not proposing to require the adviser to disclose
the names or even types of investors provided preferential terms as
part of this proposed disclosure requirement.
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The timing of the proposed rule's delivery requirements would
differ depending on whether the recipient is a prospective or existing
investor in the private fund. For a prospective investor the notice
needs to be provided, in writing, prior to the investor's investment.
For an existing investor, the adviser would have to ``distribute'' the
notice annually if any preferential treatment is provided to an
investor since the last notice.\199\ An adviser would satisfy its
distribution requirement to current investors by sending the written
notice to all of the private fund's investors. If an investor is a
pooled investment vehicle that is in a control relationship with the
adviser, the adviser must look through that pool in order to send the
notice to investors in those pools.\200\ We believe this aspect of the
proposed rule would require advisers to reassess periodically the
preferential terms they provide to investors in the same fund, and
investors would benefit from receiving periodic updates on preferential
terms provided to other investors in the same fund. We also believe
that providing this information annually would not overwhelm investors
with disclosure.
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\199\ As a practical matter, a private fund that does not admit
new investors or provide new terms to existing investors would not
need to deliver an annual notice. However, an adviser that enters
into a side letter after the closing date of the fund would need to
disclose any covered preferential terms in the side letter to
investors that are locked into the fund.
\200\ See supra section II.A.3 (Preparation and Distribution of
Quarterly Statements).
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We request comment on this aspect of the proposed rule, including
the following:
Should the proposed rule apply only to SEC-registered
advisers and advisers that are required to be registered with the SEC
instead of all advisers, as proposed?
Should we prohibit all preferential treatment instead of
the proposed approach, which is to prohibit certain types of
preferential treatment (i.e., liquidity and transparency terms that an
adviser reasonably expects to have a material, negative effect) and
prohibit all other types of preferential treatment unless disclosed?
Why or why not?
Should the proposed prohibitions apply only to terms that
the adviser reasonably expects to have a material, negative effect, as
proposed? Alternatively, should the proposed prohibitions apply more
broadly to terms that the adviser reasonably expects could have a
material, negative effect? Why or why not?
Should we prohibit all preferential liquidity terms,
rather than just those that the adviser reasonably expects to have a
material, negative effect on other investors in that fund or in a
substantially similar pool of assets? Why or why not?
Are there certain investors who require different
liquidity terms (e.g., ERISA plans, government plans)? If so, which
types of investors and what liquidity terms do they require? How do
advisers currently accommodate such investors without disadvantaging
other investors in the private fund? Should the proposed rule permit
different liquidity terms for these investor types? If so, should the
proposed rule impose restrictions in order to protect other private
fund investors? If so, which types of restrictions?
Are there practices related to liquidity and redemption
rights that the proposed rule should explicitly address (e.g., in-kind
distribution of securities in connection with a redemption, side-
pocketing of illiquid investments, discounting or eliminating the
management fee while a fund suspends
[[Page 16931]]
liquidity)? For example, should the proposed rule prohibit in-kind
distribution of securities in connection with a redemption, side-
pocketing illiquid investments, or discounting or eliminating the
management fee while a fund suspends liquidity? Alternatively, should
the proposed rule include an exception for these activities?
Should we prohibit all preferential transparency regarding
holdings or exposures of the fund or pool, rather than just prohibiting
preferential transparency regarding holdings or exposures that the
adviser reasonably expects to have a material, negative effect on other
investors in that fund or in a substantially similar pool of assets?
Why or why not?
Should we define, or provide guidance on, when
preferential redemption terms or preferential information rights would
have a material, negative effect on other investors? If so, what should
be some determining factors? Would it be relevant that the redemption
terms would cause another investor to reconsider its investment
decision? Please explain your answer. Should we clarify whether an
adviser could disclose information about holdings or exposures of the
fund or a substantially similar pool of assets on a delayed basis
without violating the proposed prohibition? Should the proposed rule
expressly require disclosure to investors after a specified period? If
so, what period?
